Inventory Management

Pareto Analysis: ABC inventory

Written by Andrew Goldman for Gaebler Ventures

Not all products are created equal. A relatively small percentage of products and materials get used the bulk of the time. By switching our management philosophy to recognize this distribution, we operate more efficiently. An example of this is applied to inventory control, as discussed in the following article.

How well we manage our inventory can have a serious effect on our bottom line.

Inventory management, especially in small businesses, can be an extremely costly process.

Using a concept known as ABC inventory, the small business can better manage their inventory and save a lot of money along the way. ABC Analysis, also known as the Pareto Principle, states that 80% of your sales are coming from 20% of your clients.

Take a minute to comprehend that statement. By understanding this distribution, we can better manage our inventory and our customers.

When talking about inventory, we can say that 20% of our inventory makes up 80% of our overall volume. While this figure may be slightly off, some internal analysis should reinforce this distribution. Measure how often your inventories turn over and you'll find that a small percentage of materials make up the bulk of your inventorying procedures.

We can split up our inventory into three basic categories; A, B and C. The A materials will be the 20% that are most crucial to your process. Depending upon your business, the A materials could be less or more than 20% of your inventory.

You want to manage your A materials the most closely. Your A level materials should be counted and ordered more frequently than other materials. Depending upon your particular business, this could be as frequent as once a week.

The B materials typically make up about 30% to 40% of your process. These materials should be monitored every month or every other month. These materials are less crucial than the A items, but still important.

The C materials are items that do not get used on a frequent basis. As a result, we do not need to check and count them regularly. We should check our C materials once or twice a year and they should not be treated the same as our A and B materials. C materials could be seasonal items or materials that are only used on a rare basis.

If we spend our time counting all of our materials, we're focusing as much on less important materials as we are on critical materials. Logically, this does make sense. By switching to the ABC inventory method, we can pay closer attention to materials that need it, and spend less time on materials that do not need it. This can be extremely valuable and result in great cost savings.

I consulted for a company that made seasonal decorative items. Depending upon the season, they had different products with different labels, ribbons and other packaging materials. The company did a physical count of their inventory on a monthly basis. It took two to three employees two days to count all of the packaging materials.

In reality, only the year-round products needed to be counted on a monthly basis, while the seasonal items only had to be counted once or twice a year. By making the switch to the ABC inventory policy, the company was able to compute month-end physical inventory counts in half a day with one employee.

Andrew Goldman is an Isenberg School of Management MBA student at the University of Massachusetts Amherst. He has extensive experience working with small businesses on a consulting basis.

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