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 from Shopify Capital to purchase inventory.)
US merchants currently sit on nearly $1.39 in inventory for every dollar in sales they make. This is a huge inventory-related expense – and the big investment exposes you to the risk of unsold goods. Properly managing inventory 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 control over inventory and profitability by helping you identify which products are high earners and costs to your business.
ABC inventory classification is based on the Pareto principle, also known as the 80/20 rule. It categorizes your inventory into three classes based on total revenue:
The Benefits of ABC Analysis in Inventory Management
Better Inventory Control
Demand forecasting is extremely difficult. How will you predict how many units you’ll sell in the next month? With no telescopes to see the future, historical data is the best thing after that.
ABC analysis highlights the highest-performing products. Use your available budget to purchase these products – they have the biggest potential to make money for your business. You’ll also see the lowest-performing products and know that you shouldn’t order them in large quantities (which would consume storage fees).
Improving Customer Satisfaction
McDonald’s is known for its french fries. Imagine the frustration you would feel if you visited the restaurant at lunchtime and they didn’t have any french fries to go with your McChicken sandwich. Customers are likely to expect a variety of products to be in stock.
By identifying your A-grade inventory, you can put processes in place to ensure you don’t run out of A-grade stock. You don’t want there to be a chance for someone to visit your store and be unable to purchase a popular item and leave empty-handed.
Making More Informed Pricing Decisions
It makes sense to invest in products that bring in the most revenue for your store. ABC analysis is a great way to discover that because it “ensures you know exactly which products are on your shelves and in your warehouse,” says Jara Muser, Digital Marketing Manager at Shopventory.
By categorizing products based on their value and performance, you’ll gain deeper insights into which products you’re losing money on, allowing you to lower prices and make way for more profitable products.
Improving Sell-Through Rate
The sell-through rate is the percentage of inventory that you sell to customers. In fact, it’s preferable to have a sell-through rate of over 80%. Having a lower amount of inventory means lower storage costs and a better understanding of customer needs. A high sell-through rate means customers enjoy the products you’re selling – and they’re voting with their wallets.
ABC analysis helps improve the sell-through rate across the entire store because you know the most popular products. Plan any upcoming reordering based on that data. Order smaller quantities of C-grade products and invest your budget in A-grade inventory. You’ll have the least amount of unsold products left in stock.
How to Implement ABC Analysis
ABC Analysis Formula
To implement ABC analysis, start by calculating the revenue generated by each individual product in your store. Divide this number by the total revenue generated by all products during the same period.
For example, if your store sold $50,000 of a serving bowl in 28 days and the entire store generated $200,000 in revenue during the same period, the serving bowl would represent 25% of the store’s revenue.
Repeat
This process is applied to each product in the inventory. Then, sort the products in descending order based on the revenue percentage they generate.
The top 80% of products are classified as Grade A products – the best items to focus on when managing inventory. The products that fall in the middle 15% are Grade B products. The products that fall in the bottom 5% are Grade C products.
Benefits of ABC analysis in inventory management
Better inventory control
Improved customer satisfaction
More informed pricing decisions
Improved sales rate
Lower storage costs
Optimized resource allocation
How to implement ABC analysis
ABC Analysis Formula
To implement ABC analysis, start by calculating the revenue generated by each individual product in your store. Divide this number by the total revenue generated by all products during the same period.
For example, if your store sold $50,000 worth of serving dishes in 28 days and the entire store generated $200,000 in revenue during the same period, then the serving dish would represent 25% of the store’s revenue.
Repeat this process for each product in the inventory. Then, sort the products in descending order according to the revenue percentage they generate.
The top 80% of products are classified as Grade A products – the best items to focus on when managing inventory. The products that fall in the middle 15% are Grade B products. The products that fall in the bottom 5% are Grade C products.
Best practices for ABC inventory management
Leverage technology
ABC inventory analysis is a straightforward method for identifying the best and worst-performing products. However, it can be challenging to execute this analysis manually. Fortunately, there are tools and applications that help streamline this process.
Shopify merchants can use Shopify POS to quickly take inventory using a barcode scanner and the Stocky by Shopify app. With these tools, merchants can significantly reduce the time it takes to inventory stock.
Analyze inventory across all locations
Additionally, Shopify merchants can view inventory reports to analyze inventory data across all locations from a central dashboard. You will see Grade A, B, and C inventory throughout the business, enabling you to make better restocking decisions and maximize storage resources. Retail merchants can also access this data directly from Shopify POS.
Use simple classifications
ABC analysis becomes complex when you analyze very granular details. Use your report with simple inventory classifications, such as revenue generated by product name or category. There is no need to break it down by color or size at this stage. (You can always do this later with an ABC analysis for each individual product.)
Optimize your inventory with Shopify
There is no doubt that ABC inventory analysis is a useful way to understand which products perform best and worst so that you can enhance sales and profitability. Remember to exclude seasonal products and new product lines, and refer back to other inventory metrics for more accurate classifications.
Prioritize Grade A inventory by making significant investments in it – whether in terms of stock levels or supplier relationships. Dispose of Grade C inventory (and reduce storage costs for unsold inventory) by bundling it with other products, selling it at a lower price, or donating it to those in need.
Getting started with ABC analysis by product in Shopify is easy. The report will use historical sales data to display the best (and worst) performing inventory in just a few clicks.
This article was originally written by Emily Manley and updated by Elise Dobson.
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