Inventory management is crucial yet costly. In fact, it’s the largest business expense. (About 69% of surveyed merchants used financing from Shopify Capital to purchase inventory.)
Merchants in the United States are currently sitting on nearly $1.39 in inventory for every dollar in sales they generate. That’s a significant expense – and the large investment exposes you to the risk of unsold goods. Proper inventory management can make or break your business.
What is ABC Analysis?
ABC analysis is an inventory classification technique that helps merchants find their most (and least) valuable products. It gives you greater control over inventory and profitability by helping you identify which products bring the most (and cost the least) value to your business.
ABC inventory classifications are based on the Pareto principle, also known as the 80/20 rule. It classifies your inventory into three categories based on total revenue:
Importance of ABC Analysis
Optimizing inventory investment is a challenge for any business. It can be difficult to know which products to purchase to meet future demand without ending up with excess inventory. Similarly, it’s nearly impossible to know which products to avoid when buying blindly or based on intuition.
Inventory management means finding a balance between providing products and reducing inventory costs. Running out of desired products can mean lost future sales – disappointed shoppers are likely to look for items from your competitors, where they may become repeat customers. Overall, retailers in the United States and Canada miss out on about $350 billion in sales each year due to stockouts and excess inventory alone.
But you don’t want to overbuy – keeping slow-moving or stagnant inventory is a financial drain. Storage fees increase year after year, so it’s essential to make the most of it. Unnecessary holding costs in the form of warehouse storage, insurance, and labor drain cash from your profits. And when perishable products expire, they can’t be salvaged, not even at discounted prices.
Businesses need to analyze inventory regularly if they want to ensure long-term success. ABC analysis is one of the best ways to manage inventory to do just that. It’s easy for Shopify merchants – just head to the reports section of your dashboard to pull an ABC analysis report by product.
Benefits of ABC Analysis in Inventory Management
Better inventory control
Forecasting demand is extremely difficult. How will you predict how many units you will sell in the next month? Since there are no telescopes to see the future, historical data is the next best alternative.
ABC analysis highlights the top-performing products. Use your available budget to purchase these items – they have the most potential to earn money for your business. You’ll also see the lower-performing products, and you’ll know not to order them in large quantities (which are likely to increase storage costs).
Improved customer satisfaction
McDonald’s is known for its fries. Imagine the frustration you would feel if you visited the restaurant at lunchtime and they had no fries to accompany your McChicken sandwich. Customers likely have the same expectations for your store. They come in expecting a range of items to be in stock.
By identifying your A-grade inventory, you can put processes in place to ensure that you won’t run out of A-grade stock. You don’t want there to be a chance that someone visits your store and is unable to purchase a well-selling product, leaving empty-handed.
Making
More Informed Pricing Decisions
It’s natural to invest in products that bring in the highest revenues for your store. ABC analysis is a great way to discover that because “it ensures you know exactly what products are on your shelves and in your warehouse,” says Jara Moser, Digital Marketing Manager at Shopventory.
“By categorizing products based on their value and usage, you can gain better insight into the slow-moving products that are losing you money, so you can lower prices and make way for higher-margin products.”
Improving Sell-Through Rate
Sell-through rate is the percentage of inventory you sell to customers. In fact, you should have a sell-through rate of over 80%. If you have products sitting in storage for a long time, it means you should have lower storage fees and better visibility for customers. A high sell-through rate means that your customers enjoy the products you sell – and that they are voting with their wallets.
ABC analysis helps improve the sell-through rate across the store because you know which products are the most popular. Plan any upcoming restock orders based on that data. Order smaller quantities of class C products; allocate more of your budget to stock class A products. You’ll have fewer unsold products in storage.
How to Run ABC Analysis
ABC Analysis Formula
To run an ABC analysis, start by calculating the amount of revenue each individual product has generated for your store. Divide that number by the total revenue generated by all products during the same time period.
For example, if your store sold $50,000 worth of serving bowls in 28 days and the total revenue for the store during that same period was $200,000, then the serving bowl would account for 25% of the store’s total revenue.
Repeat this process for each product in stock. Then, rank your products in descending order of revenue generated.
The top 80% of products are class A products – the best products to focus on when managing your inventory. The products that fall into the middle 15% are class B products. The products that fall into the bottom 5% are class C products.
Class C products are the lowest performers and are considered a financial burden. They take up space in the warehouse and prevent you from buying class A products – the products your customers actually want to purchase.
Best Practices for Inventory Management Using ABC Analysis
Leverage Technology
The days of manually counting inventory and logging it onto an Excel sheet are gone. There are tools and apps that make your life easier, especially when it comes to inventory counting.
Shopify merchants can quickly count inventory using a barcode scanner and the Stocky app by Shopify. With these tools, merchants can significantly reduce the time it takes to conduct an inventory count.
Inventory Analysis Across All Locations
Similarly, Shopify merchants can view inventory reports to analyze inventory data across all locations from a central dashboard. You will see your class A, B, and C inventory throughout the business, allowing you to make better restock decisions and maximize your storage resources. Retail merchants can also access this data directly from Shopify POS.
Use Simple Classifications
ABC analysis becomes complicated when you analyze many small details. Simplify your report using basic inventory classifications, such as revenue generated by product name or category. There’s no need to break down each by color or size right now. (You can always do that later with a mini ABC analysis for each product.)
Optimize
Your inventory with Shopify
There is no doubt that ABC inventory analysis is a useful way to identify which products are performing better and worse so that you can improve sales and profitability. Remember to exclude seasonal products and new product lines, and refer to other inventory metrics for more accurate rankings.
Identify A-grade inventory by investing heavily in it – whether in terms of stock levels or your relationship with those suppliers. Dispose of C-grade inventory (and reduce storage costs on unsold items) by bundling it with other items, offering it at a lower price, or donating it to those in need.
It’s easy to start an ABC analysis by product in Shopify. It will use historical sales data to display the best (and worst) performing inventory in just a few clicks.
Frequently Asked Questions about ABC Analysis
What is ABC analysis?
ABC analysis is a method of inventory management that involves grouping inventory items into three categories, where ‘A’ items are the most important and ‘C’ items are the least important.
What is ABC analysis with an example?
A company might use ABC analysis to divide its inventory into three categories. ‘A’ items are the most important and are closely monitored. These items may constitute 10% of the inventory but represent 70% of the value. ‘B’ items are less important, making up 20% of the inventory and 20% of the value. ‘C’ items are the least important and thus are monitored less frequently. These items may account for 70% of the inventory but only represent 10% of the value.
Where is ABC analysis used?
ABC analysis is used in supply chain management to categorize inventory based on importance.
What is the main goal of ABC analysis?
The primary objective of ABC analysis is to identify and rank the most important items in a given dataset.
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