Apr 11, 2017
Lesson 1: Inventory Classification
Are you investing time and money on items that aren’t profitable?
Bad Inventory Classification Could Be Costing Your Business 10% of Potential Sales
It is difficult to view hundreds, or even thousands, of inventory items every day and make an informed decision on what to buy, what’s running short and what you have too much of. The best way to get to the most important items is by classifying your items. Classifying your items allows you to focus on the 20% of the items that will give you 80% of the sales.
Classifying your items allows you to focus on the 20% of the items that will give you 80% of the sales.
The first thing you should do is remove all of the obsolete items. These are typically items that have not sold a single unit in 18 months to 2 years. Obsolete items will not be ordered under any circumstances – they are just noise which will distract you from your 20% of items which make up the majority of your sales.
Action: Begin by marking all of the items with no sales in the last 24 months as obsolete.
A non-stocked item is one that you keep on the price list but not in the warehouse. You will only order a non-stocked item when one of your customers orders it from you. They are typically very slow movers that your customers can’t easily get elsewhere, and they are willing to wait for delivery.
Action: Mark all items with no sales in the last 12 months as non-stocked. Make sure not to include new items that you haven’t stocked for at least 12 months.
The 80/20 principle
Now that the noise is out of the way, we should focus on the items that move regularly by classifying them into a traditional ABC based on how much forecasted sales we expect and how expensive they are.
- For every item, multiply the item’s cost price by the average monthly forecast – let’s call this number X for every item.
- Compute the sum of all X and write it down.
- Calculate two cut-off points as 80% of the summed value and 96% of the summed value, and write them down.
- Sort your list in descending order of X, with the highest values at the top.
- Start at the top of the list and mark each item as A, accumulating X values as you go.
- As soon as you get to that 80% cut-off, start marking items as B, still accumulating.
- Once you get to the 96% cut-off, mark all remaining items C.
The problem with this approach
You might have an item that is very cheap but sells 10,000 units per month. Computing its X value might result in a very low number, meaning it falls in the bottom 4% and is flagged as a C item. This item is massively important to your customers who buy it.
Apply exactly the same approach as above but based on unit sales. Now, instead of A, B or C you compute high, medium or low velocity. This velocity classification becomes incredibly powerful when it is combined with the ABC classification we computed above.