Utilising Inventory Classification

to Reduce Stock and Improve

Service Levels

The inventory planner’s

guide to ABC XYZ analysis

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© EAZYSTOCK
Contents

3 The need for ABC analysis

4 A quick overview of ABC analysis

6 The application of ABC analysis

7 XYZ analysis

8 How to calculate XYZ analysis

9 The benefits of ABC XYZ analysis

10 How inventory optimisation software can improve

inventory classification frameworks.
13 Taking XYZ analysis to another level

17 Reducing stock whilst improving service levels

20 Summary

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 The need for ABC analysis

As businesses try to compete in a marketplace that demands

variety and choice, they’re increasingly offering a wider range
of products. And whilst product choice is great for
customers, it quickly becomes a major headache for the
teams who need to manage a growing density of SKUs!

Some challenges are arguably obvious to predict.

For example, an expanding product range will often
require more warehouse space and more resources
to order, receive, pick and pack the goods.

But it’s easy to overlook the impact that customer

variety can have on a firm’s finances. By investing
more working capital in inventory, many businesses
will see an impact on their balance sheet. In addition,
they will have less money to invest elsewhere in
the business, such as in growth plans, personnel
or automation.

So, is there a way for finance managers to agree to growing their product
portfolio without seeing a working capital shortfall? The answer lies in inventory
analysis and classification.

In this eBook we’ll provide an overview of ABC and XYZ analysis and how these
frameworks can be used to classify warehouse items by their value to your
business. We’ll then discuss how inventory optimisation software can automate
this process and how the resulting data can be used to set stocking levels, safety
stock parameters and make product availability (service level) decisions.

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 A quick overview of ABC analysis

ABC analysis can be used to categorise products into three categories, based on
how much value they bring to your business.

A classification items are very important and sometimes business critical.

These typically have a high value or are sold in large volumes.

B classification items are important, but less important than ‘A’ items and
more important than ‘C’ items. These are typically mid-range in inventory
value and demand.

C classification items are marginally important. Typically, they have a low

inventory value.

‘Value’ can be defined using a range of criteria, such as annual sales revenue,
profitability or annual consumption value.

ABC analysis is based on the theory that all inventory is not of equal value. Instead
it follows the Pareto Principle, where 20% of stock accounts for 80% of the value to
the business and the other 80% of stock accounts for only 20%, as shown in this
diagram.

Diagram: ABC categorisation

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 A quick overview of ABC analysis

Therefore, in the working example below, you’ll see that at Sam’s stationery
business, 79% of the inventory are A items, 15% are B and 6% are C. However, every
business will have a unique make up of stock. The key is to set the categories
where there are obvious jumps in the data. Read our blog for more information on
how to calculate ABC classifications.

Table: Example of products broken down into

ABC categories

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 The application of ABC analysis

ABC analysis can help you identify which items in your warehouse are the most
important and should therefore consume most of your time in terms of stock control
and management.

It’s best practice to focus on your category A items, as these bring the most value to
your business and therefore warrant your upmost attention! This could include
reviewing and updating their demand forecast more frequently to guarantee stock
availability, or interacting more regularly with suppliers to improve lead times.

ABC analysis can also help you work out appropriate inventory rules for each
category.

If you’re currently treating all stock items the same in terms of the quantities you
hold and the purchases you make, you most likely have inefficient inventory policies,
and you’re probably over and under ordering on many product lines. ABC
classification will help you to set different service levels, safety stock levels and re-
ordering parameters for each category. You can then prioritise the management of
the policies based on their category classification.

For example, you may want to focus on improving the service levels of your A class
products, over your Bs and Cs by increasing your safety stock levels to avoid
stockouts.

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 XYZ analysis

ABC analysis is a relatively easy way to segment your inventory for effective
management and control. However, it does have its limitations. One problem is
that the framework is very one-dimensional e.g you can only group items based
on one criteria.

In addition, with only three categories, ABC analysis lacks granularity. With 100’s,
sometimes 1000’s of items in one segment, it’s a big generalisation to suggest
that all SKUs have the same characteristics and should be treated equally.

To help overcome these restrictions, it’s possible to introduce XYZ analysis.

XYZ analysis classifies products based on their variability of demand.

X-items = regular demand

Y-items = strong variability in demand
Z-items = very irregular and difficult to predict demand

This means you can segment items based on their forecastability e.g the
likelihood that their demand will vary from their forecast.

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 How to calculate XYZ analysis
The variability of demand for an inventory item can be expressed as the coefficient
of variation. To categorise your products into X, Y and Z you therefore need to:

▪ Identify the items you want to include in the analysis.

▪ Calculate the coefficient of variation for each item e.g (standard deviation /
mean) * 100.
▪ Sort the items by increasing coefficient of variation and accumulate the figures.
▪ Set the boundaries for each category.

It’s important to make sure that you set an appropriate time span for assessing
demand volatility. For example, if you have items with seasonal demand, it makes
sense to include 12 months of data.

With your ABC and XYZ categories identified, you can produce a matrix similar to
the one below and assign each group.

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FORECASTABILITY
 The benefits of ABC XYZ analysis

Adding another level of insight to your inventory classification allows you to make
more informed ordering and stocking decisions. For example, it makes sense to
treat AX items, that have a constant demand, differently to those with erratic
demand (AZ items). If demand is steady and easy to predict (X items), your safety
stock levels can be much lower than products where demand is much more
volatile (Z items).

You could also focus less forecasting resource on BX products, with constant
demand, than those with sporadic demand (BZ), as they should be easier to
predict and the risk of excess stock is lower due to consistent sales.

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 How inventory optimisation software can
improve inventory classification
frameworks

ABC XYZ analysis is used by a number of enterprise resource planning (ERP)

systems to categorise stock and set inventory policies. But to take inventory
classification to the next level, you require an inventory optimisation plug-in,
such as EazyStock. Advanced inventory optimisation software will analyse every
SKU across your business against a multi-dimensional set of criteria. This can
include:

Demand volume – no of units sold over the set period

This is the most common way of doing an ABC classification, separating high
and low volume products. It doesn’t, however, make allowance for individual
customer requests (no. of picks) or the cost price of the products being sold
(value of annual usage).

This is useful if your product range has similar unit costs and your customer
base typically buys in a regular way (for example you sell only to retailers or only
to wholesalers). This is less useful when you have products with a range of unit
costs, or a mixed customer base.

Sales frequency – what % of historical periods had a sale

This is important when you want to ensure demand with a certain level of
consistency across a specific time period. Frequency is often analysed over a
different time period to the other dimensions. For example, if you have very short
supplier lead times you might want to assess how many times you’ve had
requests for particular products within a three-month period.

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 How inventory optimisation software can improve inventory
classification frameworks

No. of picks – number of times items are picked over the set period
This accounts for the number of unique customer requests over a time period.
This allows you to separate high volume products with many requests (1000
requests for 1 unit) vs. high volume products with low requests (2 requests for
500 units). Isolating by the number of customer requests is very important when
you have a mixed customer base.

Value of annual usage – sales volume x unit cost over the set period
This takes into account sales as well as making allowances for how much each
product costs per unit. This distinction is very important when you have products
with a range of unit costs.

With inventory optimisation software the result is a far more advanced and
accurate inventory classification matrix that allows you to set tighter and more
accurate inventory policies.

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 How inventory optimisation software can improve inventory
classification frameworks

Here’s how it works:

The example below shows an inventory policy matrix using Value of Annual Usage
and Pick Frequency. Based on the data, EazyStock has recommended which items
should be stocked (boxes in blue) and those which should be ordered on demand
(boxes in white).

Adding pick frequency allows you to distinguish between a valuable category A

product that sells once a year (A1 / P1) and one that sells 1000’s of times (A1 / P8).
By understanding how often a product is requested, EazyStock will then offer more
informed inventory management decisions (see page 17).

For example, in the chart above, the system is recommending that valuable, fast
moving A1 / P8 items that sell consistently should be stocked to a high density,
whereas A1 / P1 items that sell very rarely should not be stocked at all. EazyStock
therefore segments down the ABC categories to a more granular level, so more
accurate inventory policy decisions can be made.

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 Taking XYZ analysis to another level

In the previous chart it appears that demand variability (the XYZ factor) has been
overlooked – far from it. EazyStock takes XYZ analysis to another level by
analysing the demand volatility of every SKU and assigning them one of nine
demand types.

Every product in your warehouse has a specific demand pattern that makes it
easier or more complex to forecast e.g its forecastability. EazyStock groups
items into one of the demand types below, based on their historical sales
pattern.

Diagram: EazyStock demand types

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 Taking XYZ analysis to another level

Despite looking very different, some of these demand types have similar demand
volatility behaviour, in terms of how easy their demand is to forecast. For this
reason EazyStock groups them into three categories, similar, but more
sophisticated in their calculations to the XYZ framework.

1. Normal

2. Slow

3. Lumpy

These demand types are automatically taken into account when classifying
inventory in EazyStock and are used to segment the inventory policy matrix down
further from 81 to 243 groups.

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 Taking XYZ analysis to another level

In the matrix below you can see eight pick classes on the left-hand side, then the
associated number of picks. Across the top the items are classified by their value
of annual usage (VAU). Each segment is then broken down further by demand
type: normal, slow and lumpy.

Diagram: Example of an EazyStock inventory

matrix

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 Taking XYZ analysis to another level

Including demand variability adds another level of inventory classification. For

example, products with a lumpy demand are inherently more risky - as sales occur
intermittently and sales volumes vary. So when you do get demand, its size could
be within a wide range of possible values. This means you require more safety
stock to cover for the demand variability, in order to achieve a high service level.

As more safety stock means proportionally more invested capital compared to the
other demand types, companies would typically go for lower service levels across
the matrix on lumpy products, in order to keep their capital free to invest in more
regular items. However, there are always exceptions to this rule, for example if the
lumpy product is business critical (category A) you may aim for a higher service
level in spite of the cost.

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 Reducing stock whilst improving service
levels
If you carry out an ABC analysis manually your next step would be to review and
set your inventory policies, based on the results. And this is exactly how
EazyStock works.

With all items now categorised in to 243 segments, EazyStock then

recommends service levels that you should achieve to optimise your operational
performance.

A service level is the probability of not having a stockout. So a 99% service level
means there’s a 99% chance that you’ll have a product in stock when a customer
orders it.

For example, in the inventory policy matrix below the service levels could be set
as follows:

Light Blue – 99%

Blue – 95%
Dark Blue – 90%

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 Reducing stock levels whilst improving service levels

In the EazyStock system the inventory policy matrix would look similar to this:

As you can see, EazyStock calculates the recommended service level for each
category. It then recommends the minimum amount of inventory you need to
carry to meet your required service levels. This is so you can reduce the levels of
stock you hold but still ensure availability, particularly for products that are the
most valuable and most frequently requested across your business.

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 Reducing stock levels whilst improving service levels

If required, service levels can also be overridden e.g if you know you need to keep
an A1/P1 product in stock in case your best customer requests it, despite only
doing so once a year.

It’s also possible to simulate service level alterations. For example, if you wanted
to understand the cost implications of increasing your service levels, EazyStock
will simulate the results.

Producing inventory policies for easier management

In the same way that you would produce inventory policies to manage your ABC
product categories, EazyStock calculates management rules for every SKU in the
matrix to ensure you hit your service levels.

This includes setting safety stock levels and replenishment alerts, ultimately
providing a list of items and quantities to re-order. You can then decide whether
to review the orders (which you may do for valuable, slow moving items) or
simply automate the process (which you may do for faster moving, low value
items where the risk of excess stock is low).

Unlike manual inventory classification frameworks, EazyStock will continuously

analyse your stock to ensure each SKU falls into the right category and is
managed by the right inventory policy.

By managing by exception you can free up your time to make informed, strategic
decisions, instead of wasting it ‘number-crunching’.

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 Summary

Stock the right products

For organisations looking to expand their product portfolio and carry
a deeper breadth of SKUs, the need to reduce inventory levels is
critical to ensure operational efficiency and growth. To do this,
businesses need to understand the make-up of their inventory and
set policies that achieve high service levels (product availability) with
the least amount of stock.

ABC analysis, whilst simplistic, is a useful framework to help businesses move

away from a ‘one-size-fits-all’ approach to inventory management and begin to
understand which products to stock and in what quantities.

Adding the further dimension of XYZ analysis allows classification decisions to

be made based on demand volatility, as well as value, improving the accuracy of
inventory policies.

For a more sophisticated and automated approach software, such as EazyStock,

may prove a valuable investment. With its ability to undertake more complex
stock analysis and provide inventory policies at SKU level, businesses can
benefit from much tighter and more accurate control.

EazyStock is designed to ensure businesses carry

the right stock, in the right quantities, to meet
demand. With leaner inventory levels, informed
purchasing and faster order management
processes, business can steel an advantage
over their competitors. But
the real win is their ability to
free up working capital and
improve their bottom line.
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 Find out more about
inventory optimisation

www.eazystock.co.uk

Contact [email protected]

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