We’ve talked a good bit on this blog about the Pareto Principle and its prevalence in life and business. The Pareto Principle (also known as the “80/20 rule”) states that 80% of your production comes from 20% of your producers.
In business, we see this everywhere. 80% of our complaints come from 20% of our customers. 80% of our web traffic comes from 20% of our highest-performing blog posts and pages.
Though we can expect some variance in the numbers, there’s a reason this business truism has persisted for so many decades.
The principle applies in many facets of warehouse and inventory management as well. 80% of business value often comes from 20% of product.
So how can you practically apply this principle in your business? Enter ABC inventory management.
At its heart, ABC inventory management is a discipline that seeks to “major in the majors.” In other words, with all things being equal, we want to sort the high, medium, and low producers in our warehouse and treat them accordingly.
It’s the Pareto Principle taken to its logical conclusion in the warehouse.
What is ABC analysis for inventory management?
More to the point, an ABC analysis is the practice of sorting all your inventory into three categories — A, B, and C.
Products in the A category have the highest monetary impact on your business. I say “impact” and not “benefit” because their theft or obsolescence can decimate your bottom line. In other words, they’re the most important.
Products in the B category have a lesser but still significant impact on your business.
Products in the C category have minimal impact on your business. This may be because they’re low-cost, low-demand, or afford tiny profit margins.
What are the benefits of using ABC analysis?
At Linnworks, we don’t believe in crunching data for data’s sake. You should never adopt a new inventory management or ecommerce technique because of its trend factor.
It’s essential to understand the business value behind ABC analyses before engaging in the nuts of bolts of calculations.
So what’s the point of this exercise? There are three notable benefits:
ABC analysis helps you identify the highest-value items
You might think that selling a lot of a particular SKU means it’s your highest value item. But how does that intersect with your profit margins? How about the overall cost of purchasing, storing, and shipping?
ABC analysis is great because it takes the assumptions out of inventory management. As we’ll see later in this post, it uses data to cut through the fog and discern what’s generating the most value.
These insights may lead you to reconfigure your warehouse altogether. You might geographically prioritize your high-value items or protect them more intentionally.
ABC analysis necessitates inventory accuracy
Because good data is the foundational first step in ABC analysis, it has the added benefit of requiring warehouse managers and ecommerce businesses to stay on top of their data and keep it clean.
Sometimes, having a motivating factor is what we need to continue with productive business habits, and ABC analysis provides that through its dependence on good, timely, thorough inventory data.
ABC analysis enables cycle counts
Probably the most significant way ABC analysis helps your business is by laying the groundwork for cycle counts. We can’t overstate the importance of this to the profitability and efficiency of your warehousing operations.
If you’re curious, check out our deep-dive on cycle counting and how to implement it in this post.
First off, we need to start with the presupposition that counting inventory is essential (I hope we don’t need to convince you too strenuously of that fact).
The challenge is how you count inventory. The traditional audit model requires shutting down all operations, paying workers overtime to count, and subsequently causing disruptions in supply chains and lead times.
For small warehouses, you may be able to get away with this. But as your SKU counts and employees grow with your business, this method isn’t sustainable.
Cycle counting is the practice of cyclically counting only certain items during warehouse hours. While it’d be ideal to have all the employees count everything during work hours, that’s just not realistic.
So the answer is only to count specific items during work hours. But how do you decide which things to prioritize?
That’s where ABC analysis comes in. See how everything is connected? ABC analysis helps you prioritize the most high-value items, and thus the items that deserve more attention and more tight counting controls and prioritization in counting schedules.
The amount of money and headaches you could save by implementing cycle counts is reason enough to perform ABC analyses on your inventory.
What are the drawbacks of using ABC analysis?
There’s no perfect warehouse solution or philosophy. The critical mindset to have as a warehouse or ecommerce business owner is to be flexible.
Over the decades, certain best practices have proven themselves as solid solutions, but no two businesses are the same. You need to custom-tailor these solutions to your own business needs — and be willing to change when necessary.
The ABC analysis model certainly isn’t perfect, and relying on it alone as your North Star of inventory decision-making is unwise. Here are some things to consider in regards to the ABC analysis model.
The ABC analysis model tends to be inflexible
The problem with calculating fixed data sets in Excel or Google Sheets is that they don’t reflect ever-changing, real-time inventory data. They don’t account for things like seasonal demand, forecasting variables, and historical buying patterns.
This is why it’s crucial to have an IMS like SkuVault Core to analyze sales on an hour-by-hour basis. Products can flow fluidly across ABC category boundaries without you needing to go back on and recalculate all the numbers.
The ABC analysis model only looks at revenue, not “soft” metrics
The most important KPI in a business is its revenue. We’re not going to argue against that — cash is king.
But there are other qualitative metrics — sometimes called “soft” metrics — that can significantly impact a business’s growth.
For example, suppose there’s a low-price, loss-leading product that gets customers in your CRM and helps you remarket higher ticket products.
In that case, that product has a lot of value as a “gateway SKU” that isn’t reflected in traditional ABC analysis — because there’s no direct revenue signal pointing to this product’s power to build overall lifetime value.
ABC analysis is an essential piece of the larger picture, not an end-all-be-all system for drawing conclusive insights.
How to calculate an ABC inventory analysis
Doing an ABC analysis is quite simple. The calculations aren’t the challenge — the challenge is having accurate data to calculate.
When you do calculations with bad data, that’s not a reflection of reality. Basing business decisions off of anything other than reality is a recipe for failure.
This is just another reason to invest in an IMS that can manage your inventory numbers in real-time across multiple channels. You can have confidence in an automated IMS system that you’re working with data scanned in and reconciled by technology, not contingent upon human data entry.
With that caveat out of the way, here’s the five-step process to performing an ABC analysis in your warehouse:
- Gather all inventory data
- Find each SKU’s value
- Calculate your inventory’s total value
- Calculate each SKU’s contribution to that total value number
- Sort your inventory into the appropriate A, B, or C categories
Let’s go through each of these steps together in a hypothetical example.
ABC analysis calculation example
Abstract mathematical concepts are always easier to understand when you create a story around them.
Let’s say we own a small ecommerce shop that sells high-quality coffee brewing equipment and accessories.
We’re sick of feeling uninformed about the value each product brings to the organization. We want to prioritize our employees’ time via cycle counting and mitigate shrink risk around high-value items.
An ABC analysis provides solutions to these problems. Let’s go through the framework mentioned above step-by-step.
Step 1: Gather all inventory data
There are lots of pieces of data we could gather, but we’re only concerned with two for each item:
- The annual demand – the average number of yearly purchase attempts, including those that failed due to stock-outs
- The unit cost – the average total expenditure incurred by your business to produce, store, and sell one unit of a particular product
Annual demand should be relatively easy to extrapolate, even without an IMS. However, determining your unit cost may be a bit trickier. If you don’t have reporting functionalities that can produce this information, you can use this valuation method to come up with a rough estimate.
Also, you can use the unit price (cost to the customer) in a pinch instead of the unit cost. The two are often correlated.
We’d recommending downloading this data in a CSV, if possible, and doing these calculations in Excel or Google Sheets.
Our hypothetical sales data formatted in a spreadsheet may look something like this:
|Automatic pour-over machine
|Electric gooseneck kettle
Step 2: Find each SKU’s value
To find the value of each item, simply multiply the annual demand by the total cost. In Excel, you can set up a simple formula in the D2 cell (“=B2*C2”) and then click and drag down through each filled cell to populate the spreadsheet.
With our above data, it would look something like this:
|Automatic pour-over machine
|Electric gooseneck kettle
Step 3: Calculate your inventory’s total value
We now need to calculate the total value of all our inventory.
This is simply done by calculating the sum of the fourth column (probably column D if you’re following along).
Click one cell below your final item (D6 in our example), and enter “=SUM(D2:D5)” to calculate this total automatically.
In our case, the total value would be $361,000.
Step 4: Calculate each SKU’s contribution to that total value number
This is where the fun part begins.
Now that we know the value each SKU adds to our business and the total value of all our inventory in dollars, we can start assigning percentages and subsequently sort them into ABC categories.
We’ll want to start by adding another column (E) and naming it Percentage. Next, we need to divide each SKU’s value by the total value to find the percentage.
Once again, spreadsheets make this easy. Just enter “=D2/$D$6” into E2, and drag it down to apply it to all the data.
You should see some unattractive decimal points. To fix this, highlight the column, navigate to Format, and change your data layout to Percent.
Step 5: Sort your inventory into the appropriate A, B, or C categories
Here is our final data table (sorted from most to least valuable). That wasn’t so bad, was it?
|Automatic pour-over machine
|Electric gooseneck kettle
Now it’s time to sort our items into A, B, and C categories.
There are no ironclad rules for where the thresholds for each category begin or end. Don’t be afraid to use a bit of subjectivity and common sense. You also need to have an eye toward your unique business goals.
That said, here are some excellent starting points:
A Category – products that equal a combined value of 60-90% of your total inventory value
B Category – products that equal a combined value of 30-60% of your total inventory value
C Category – products that equal a combined value of 10-30% of your total inventory value
Our automatic pour-over machine is our golden goose. This product alone accounts for 83% of our inventory value. For that reason, we’ll want to prioritize this item for regular counts and keep it stored in a geographically central and protected area of the warehouse.
We may even decide to double-down on our R&D to develop similar products or put more cash into manufacturing this particular SKU.
Are you starting to see the value of this exercise?
When combined, our electric kettle and grinder make up around 17% of our inventory value. While this doesn’t reach the threshold of the B category, we might decide to tweak it to suit our business goals (this is where subjectivity and common sense come in).
In our case, the kettle and grinder would fall into the second tier (B category). They’d be subject to fewer cycle counts than the pour-over machine but still stored centrally in the warehouse.
The final category, the C category, would be home to our self-heating mug. We’d count these products infrequently and store them in less central locations.
Depending on your cycle count cadence, you can sometimes go several months or a year without counting SKUs in this category and not feel the hurt on your bottom line.
Final thoughts on the ABC analysis example
This example was intentionally simple. In your case, you may have dozens of SKUs to sort through. Take your time, go through the formulas step-by-step, and don’t forget to save your ABC analysis spreadsheet as a template for a more efficient workflow next time you need to make your calculations.
ABC analysis implementation best practices
Before you hurry off to do your own ABC analysis, consider these best practices. These shortcuts will help you get even more out of this humble but effective inventory analysis method.
Automate wherever possible
Even with a saved template, gathering the data to regularly perform these analyses by hand will get old. It’s important for ecommerce professionals to stay out of the weeds and free themselves up to make high-level decisions for the business.
A dedicated WMS or IMS can take care of automating all the essential data and generate valuable reports to aid you in your ABC analyses.
For example, using SkuVault Core’s Class/Brand report, you can quickly classify all your SKUs into logical buckets (books, clothes, furniture, general, or whatever else you specify). From there, you can see at-a-glance metrics on each category’s inventory value, sold cost, profit, markup, and more.
This is not only helpful for quickly extracting accurate and up-to-date data, but for making high-level business decisions beyond the scope of ABC analyses.
Make ABC analysis a regular part of your monthly or quarterly strategy meetings
The ABC analysis is the perfect report to show stakeholders or investors. It’s data-driven enough to be important but simple enough to be easily digested in a 20-minute meeting.
It’s especially helpful if you’re looking to make changes to your warehousing operations and need a justification to do so. Plus, it helps your stakeholders see that you’ve got your fingers on the pulse of which products add value to the organization.
Stack reorder point calculations with ABC analysis
If you want to set yourself up for success, we recommend stacking ABC analysis with your reorder point calculations.
This will give you a truly data-driven inventory management strategy and a clear roadmap to profitability.
Reorder points are the points at which you must reorder product in order to avoid stock-outs. Reorder point calculations must be performed for each SKU, but with a warehouse full of SKUs, prioritizing which to calculate first can be daunting.
Unless you use ABC analysis first. Once you’ve identified your highest performers, you can make sure you shore up their reorder points first.
And going even further, you can make tweaks to your reorder point calculation based on the value these products bring to the organization.
For example, you may want to keep a more conservative safety stock for high-value items, as stock-outs would ultimately be more costly to your bottom line.
Conversely, you can be more aggressive with keeping less safety stock (and therefore less capital tied up in inventory) with products in the C category.
Keep your data clean
We’ve mentioned this several times in this post, but we can’t overstate its importance: the best way to make profitable business decisions is to operate from a foundation of clean data.
The best way to ensure your data is clean is to use an IMS. SkuVault Core not only ingests and manages your data from multiple sales channels in real-time but can also help you forecast demand and automate reorder points.
All this in addition to giving you a bevy of reports to help you understand your most profitable items and how to grow your business.
To learn more about how SkuVault Core can automate the tedium of inventory management and business growth, reach out to our team for a live demo today.