Warehouses contain the following three types of inventory:
- Fast-moving: items that sell out almost as fast as they're is produced
- High-value: items that sell infrequently
- Hybrid: products that sell moderately quickly
Businesses that carefully classify their warehouse products are better able to efficiently stock inventory.
In 1951, General Electric was the first company to classify its warehouse inventory with a process known as the ABC methodology, after an employee named H. Ford Dickey suggested sorting items based on sales volume, lead-time, cash flow or stockout costs. In this system, Group A contained items that had the highest impact on the company's bottom line, while the Group C group contained items with the lowest impact.
This system heavily relied on The Pareto Principal--also known as the 80/20 rule, which states that for many events, roughly 80% of the effects come from 20% of the cause. In other words, a few chief products drove the majority of profits. This means that most warehouse items have far less impact. Supply chain or logistics departments accordingly make decisions, based on this data. Some large companies use more than three groups to silo their warehouse inventory--particularly if they have complex cycle counting requirements.
Here are some general classification rules:
- Group A inventory accounts for about 20% of warehouse items and 80% of dollar usage
- Group B inventory accounts for about 30% of the items and 15% of dollar usage
- Group C inventory accounts for about 50% of the items and 5% of dollar usage
Instead of dollar usage, some companies rely on other criteria, such as transaction usage, unit cost, lead time, and carrying costs.
Performing an ABC Classification
Many companies perform the ABC classification either by using an enterprise resource planning (ERP) system, a proprietary inventory control system, or by downloading data into an Excel spreadsheet. In any case, after calculations are made, and items are assigned to their relevant groups, logistics departments typically review the results, to make sure they are sound.
As with any calculated value, there may be anomalies that cause items to be improperly sorted. A typically slow-selling item that may experience an unusual spike in sales, could be erroneously assigned to group B, when it should be placed in group C. Logistics departments may subjectively adjust the ABC results, to ensure the most accurate classification possible.
ABC classification is often used cycle counting. This is where fast-moving warehouse inventory is regularly counted, while inventory of less import is counted less frequently. For example, Group A items may be counted monthly, while Group C items may be counted only once every six months.
This article has been updated by Gary W. Marion, Supply Chain and Logistics Expert for The Balance.