Inventory management is critical but costly. In fact, it is the largest business expense in running a business. (About 69% of surveyed merchants used financing through Shopify capital to purchase inventory.)
Merchants in the United States currently sit on about $1.39 of inventory for every dollar of sales they generate. It’s a significant expense, and the large investment exposes you to dead goods risk. Proper inventory management can make or break your business.
What is ABC Analysis?
ABC analysis is an inventory classification technique that helps merchants find the most (and least) valuable products. It gives you greater control over inventory and profitability by helping you identify products that deliver the greatest value and cost to your business.
The ABC inventory classifications are based on the Pareto principle, also known as the 80/20 rule. It classifies your inventory using three categories based on total revenue:
- Category A: This is the top-performing inventory: the money maker. Products with the highest annual consumer value and customer demand. Category A represents the specific inventory – in many cases, only a small percentage of the total – that accounts for 80% of your revenue. Being your most valuable inventory, it should be protected and prioritized as much as possible.
- Category B: This is the average-performing inventory that represents 15% of your revenue, and should be treated as such. Inventory in category B can fluctuate between category A and category C.
- Category C: This is the lowest-performing inventory. Category C represents the specific inventory that makes up 5% of your revenue. This can be called slow-moving or dead inventory. Inventory in category C adds little value to your business and should be deprioritized as much as possible.
The Importance of ABC Analysis
Optimizing inventory investment is a challenge for any business. It’s hard to know what products to buy to meet future demand without having excess leftover stock. Similarly, it’s almost impossible to know which products to avoid when buying blindly or based on intuition.
Inventory management means finding a balance between supplying products and reducing inventory costs. Running out of requested products can mean missing out on future sales – disappointed shoppers may look for items from your competitors, potentially becoming repeat customers. Overall, merchants in the United States and Canada miss about $350 billion in sales each year due to stockouts and excess storage alone.
But you don’t want to buy too much – keeping dead or slow-moving inventory costs you money. Storage fees increase year after year, so maximizing your inventory is crucial. Unnecessary carrying costs in the form of storage, insurance, and labor drain money from your profits. When perishable products expire, they cannot be salvaged, even at discounted prices.
Businesses need to analyze their inventory regularly if they want to ensure long-term success. ABC analysis is one of the best inventory management methods to achieve this. It’s easy for merchants on Shopify – just head to the reports section of your dashboard to extract an ABC analysis report by product.
Benefits of ABC Analysis in Inventory Management
Better control over inventory
Forecasting demand is extremely difficult. How will you predict the number of units you will sell during the next month? Since we don’t have crystal balls to see the future, historical data is the best alternative option.
ABC analysis highlights the top-performing products. Use your available budget to purchase these products – they have the greatest potential to earn money for your business. You will also see the underperforming products, and you’ll know not to order large quantities of them (which are likely to incur storage fees).
Satisfaction
Optimized Customers
McDonald’s is known for its fries. Imagine the frustration you’d feel if you visited the restaurant during lunch and there were no fries to accompany your McChicken sandwich. Customers likely have similar expectations for your store. They come with the expectation that a number of items will be in stock.
By identifying your category A inventory, you can set processes to ensure that you never run out of category A stock. You don’t want there to be a chance for someone to visit your store and not be able to buy a top-selling product and leave empty-handed.
Better-Informed Pricing Decisions
It makes sense to invest in the products that bring in the most revenue for your store. ABC analysis is a great way to uncover this because “it ensures you know the products on your shelves and in your warehouse,” says Jara Moser, Digital Marketing Manager at Shopventory.
“By classifying products based on their value and movement, you can get a better view of the slow-moving products that are costing you money, so you can mark them down and make room for more profitable products.”
Improved Sell-Through Rate
The sell-through rate is the ratio of inventory sold to customers. In fact, your store should have a sell-through rate of over 80%. If there are products sitting in storage for a long time, that means lower storage fees and a better understanding of customer preferences. A high sell-through rate means your customers are enjoying the products you sell – and they’re voting with their wallets.
ABC analysis helps improve the sell-through rate across your entire store because you know which products are most popular. Plan any upcoming reorder requests based on that data. Order smaller quantities of C category products. Put more of your budget into A category inventory. You’ll have fewer unsold products in storage.
How to Implement ABC Analysis
ABC Analysis Formula
To implement ABC analysis, start by calculating the amount generated by each product for your store individually. Divide this number by the total revenue generated from all products during the same time period.
For example, if your store sold $50,000 worth of serving bowls in 28 days and the entire store generated $200,000 in revenue in the same time period, the serving bowl would represent 25% of the store’s revenue.
Repeat this process for each product in inventory. Then, rank the products in descending order based on the revenue generated percentage.
The top 80% of products are category A products – the best products to prioritize when managing inventory. The middle 15% of products are category B, while the bottom 5% are category C.
Businesses need to analyze inventory regularly if they want to ensure long-term success. ABC analysis is one of the many methods you can use for this. It’s easy for merchants on Shopify – just head to the reports section of your dashboard to pull an ABC analysis report by product.
Example of ABC Analysis
Here’s an example of ABC analysis for a home decor brand. It classifies SKUs into categories A, B, and C based on the revenue generated percentage by each product for the store.
Serving bowls and serving trays are category A products. This merchant should ensure that they always have these products in stock, perhaps featuring them on the homepage or in a best-sellers product group in their online store. If they are also selling in person, they can display them in high-traffic areas of their store (such as the checkout counter for impulse buys).
Groups
The plates and cup sets, along with glassware sets, on the other hand, make up Category C products. The trader may consider not carrying those items anymore, improving the products themselves, or running additional promotional offers.
Category A Strategies: What to Do with the Best Inventory
Maximize the benefits of ABC analysis by focusing on Category A products. Here are seven tactics you can apply to Category A inventory products to maximize your sales and profits.
Build Strong Relationships with Category A Suppliers
Business is based on relationships, and this doesn’t stop with your suppliers. Category A suppliers are those you want to grow with. Not only will your supply chain and reorder process be more efficient, but as the relationship with the supplier evolves, communication improves.
Suppliers will know who is manufacturing the products for them, and merchants will understand the manufacturing process from the supplier’s side. This helps mitigate any delays in the supply chain, so you won’t be let down by a supplier who can’t provide Category A stock.
Additionally, if you are easy to work with, you may also benefit in other ways – better prices, faster delivery, and preferential treatment for your Category A products.
Want to know how to improve your relationships with suppliers? Here are some supplier relationship management tips to keep in mind:
- Ensure clarity in what you want to order. Small discrepancies can cause headaches for you and your suppliers.
- Put your order in writing. Create and send purchase orders so that everything is documented and all parties remain on the same page.
- Pay on time. Timely payment should be a given, and this also builds a good reputation for your business.
- Get to know your supplier’s business. Understand your supplier’s business so you can gauge the right timing for deliveries and build empathy around their constraints.
- Communicate on a personal level. Remember, all business is founded and run by people.
Identify Multiple Suppliers for Category A Products
While you want to establish a positive relationship with your supplier, that doesn’t mean you can’t look for other options as well. In fact, it’s crucial to establish a strong supply chain, and this is particularly important for Category A products – especially when preventing stockouts of your high-value products.
Suppliers may face manufacturing capacity shortages if they encounter unexpected or uncontrollable circumstances, such as numerous purchase orders, maintenance accidents, or equipment breakdowns. These challenges can increase prices, affecting your recovery point and negatively impacting your profit margins. In the worst cases, your supplier could shut down or stop manufacturing the high-demand products you need, forcing you to look for a backup.
So, strengthen your supply chain by identifying multiple suppliers, or at least a backup supplier, for all your Category A products. This backup network will safeguard your supply chain and reduce the risk of costly stockouts.
Always Ensure Category A Inventory is Available
Remember that stockouts cost merchants nearly $350 billion in sales in one year. It is vital to ensure that Category A products are always in stock, as they represent the top-performing products that customers are highly demanding.
Many shoppers will specifically look for these products. If you don’t have them, it leaves a bad impression. This is where backup inventory comes into play – a small surplus of stock that you keep for cases when market demands or lead times change. You can calculate backup inventory in several ways. Market fluctuations, supply chain reliability, and the cost of holding the inventory you wish to maintain will influence the amount of backup inventory needed.
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The basic formula for calculating the safety stock for A category products is:
Safety stock = (Maximum daily sales × Maximum lead time in days) – (Average daily sales × Average lead time in days)
You can obtain all these metrics directly from Shopify. To determine the maximum daily sales volume, use the “Sales over time” report and the “Variant” filter to identify the daily sales of the unit for which you want to calculate the reorder point. From this view, you will be able to determine the maximum daily sales over a specified period.
Average daily sales refer to the number of units a specific product sells over a defined period. To determine this, refer to the “Average daily sales of stock sold” report in Shopify.
Suppose you sell 1.5 units of the serving bowl daily.
Average lead time refers to the duration it takes to receive an inventory shipment. To obtain this, divide the total wait time for purchase orders by a specified period.
You learned that the longest wait for a purchase order was 15 days, but on average, it takes 10 days to receive the serving bowl from the supplier. Therefore, the safety stock is: (5 × 15) – (10 × 1.5) = 60 units.
Determining the Reorder Point for A Category Inventory
Once you know the optimal inventory levels for A category inventory, you can determine the reorder point for those products. This allows you to prevent stockouts and ensure automatic purchasing.
The reorder point is a simple calculation that tells you the minimum amount of inventory you can hold before you need to order more to maintain the optimal inventory level. You can calculate the reorder point for each individual product (or variant) that you sell.
Reorder point = (Average daily unit sales × Average lead time in days) + Safety stock
Using the same example above, the reorder point for this merchant is: (1.5 × 10) + 60 = 75 units.
In Shopify, use the “Monthly inventory snapshot” to monitor your inventory quantities for A category products. Once the quantity of the product or variant reaches the reorder point (i.e., 75 units), you know it’s time to order more products.
Investing More in A Category Inventory
Since A category inventory is your highest-value inventory, it is likely a good idea to invest more in these products, especially if demand is stable and sustainable.
In some cases, you may want to order larger quantities of inventory from your suppliers so you can sell more. Alternatively, you can increase your spending on marketing and advertising for A category products to boost demand and sales.
Increasing Prices for A Category Inventory
Setting product prices is a challenge in itself and many variables should be considered. Target audience, product costs, revenue goals, competitor pricing, product seasonality, and market trends all play a role.
However, since the demand for your most valuable inventory is highest, you may want to consider raising prices slightly to increase your profit margin. Review your pricing strategy for A category products. Would shoppers be willing to pay more for their favorite products? If so, you can enhance net profits.
Securing and Controlling A Category Inventory
A category inventory consists of high-performance and highly demanded items. This inventory should be handled and protected as such. Provide better security and control for A category inventory to ensure it remains safe and in good condition so that you can sell it.
Unfortunately, products can be lost, damaged, or even stolen. To prevent this from happening to you, you may want to consider the following ideas:
- Insurance
- Monitor class A inventory using a security system and video surveillance. External logistics partners (3PLs) likely already have strong security procedures in place.
- Conduct regular cycle counts. This will help you discover discrepancies early on.
This inventory is secured by multiple locks, security guards, and other security measures, especially if you are using your own warehouse or keeping the inventory at home.
For inventory in multiple warehouses or retail locations, you can also use Electronic Article Surveillance (EAS), cameras, RFID tags, and assembly security.
Get more class A inventory
Through Shopify Capital, eligible merchants can apply for funding to invest in class A products so that they are always available in stock. With automatic repayment, you can s
Source: https://www.shopify.com/blog/abc-analysis
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