Inventory Classification: Methods, Example, and Best Practices

What is Inventory Classification?

Inventory Classification, as the name says, is classifying the products in an inventory as per their demands, value, the revenue they bring in, carrying costs, etc. This is more or less like ABC analysis, wherein the products in the inventory are segregated into three categories: Category A holds the 20% of the products that bring 80% of revenue to the business, Category B holds the 30% of the products that bring in 15% of revenue, and Category C holds the 50% of the products that bring in the remaining 5% revenue.

The below-mentioned reasons also help in segregating the products from an inventory:

Fast-moving – items that sell at a quick pace; sell as soon as they are manufactured/produced and moved in the warehouse

High-value – items that bring in the highest revenue, but sell infrequently

Hybrid – products that remain in between; sell moderately

History and how ‘Inventory Classification’ came into use.

For the very first time, in 1951, General Electric was the first company to experiment “Inventory Classification” in its warehouse with a process named ABC methodology. This was suggested by an expert employee named H. Ford Dickey, keeping in mind the sales volume, cumulative lead-time, cash flow or stockout costs, revenue, the value of the product, etc. Here, Category A comprises of all the items that had the highest impact on the company’s finances, while Category C comprised of the items that had the lowest impact.

Benefits of Inventory Classification

• Optimized Inventory Control:
  Classification helps in applying different levels of control and management strategies to different categories of inventory. It allows businesses to focus their efforts and resources where they are most needed, optimizing inventory control.
• Better Demand Planning:
  By classifying items based on their demand patterns, businesses can make more accurate demand forecasts. This, in turn, helps in avoiding stockouts and overstock situations, improving overall customer satisfaction.
• Improved Ordering Decisions:
  Classification allows for a more strategic approach to ordering. High-value or high-demand items may require more frequent orders in smaller quantities, while low-value or slow-moving items can be ordered less frequently in larger quantities, aligning with the economic order quantity (EOQ) model.
• Cost Optimization:
  Inventory classification facilitates cost optimization by tailoring inventory management practices to the specific characteristics of each category. This can lead to reduced holding costs for slow-moving items and minimized stockouts for fast-moving items.
• Enhanced Supplier Relationships:
  Businesses can work closely with suppliers based on the classifications of items. For critical or high-value items, a more collaborative and responsive relationship with suppliers may be established, ensuring a reliable and efficient supply chain.
• Space Utilization:
  Efficient use of storage space is essential for businesses with physical inventory. By classifying items based on size, weight, or storage requirements, businesses can optimize warehouse space and reduce storage costs.
• Cycle Counting Accuracy:
  Inventory classification supports more accurate cycle counting. High-value or high-demand items may be counted more frequently, ensuring that their on-hand quantities are consistently accurate.
• Resource Allocation:
  Proper inventory classification helps in allocating resources effectively. Businesses can allocate manpower, technology, and financial resources based on the specific needs and characteristics of each inventory category.

Other Inventory Classification Methods

Outside of ABC Analysis which we mentioned above there are a few other classification methods worth mentioning.

1. XYZ Analysis

Criteria: Classifies items based on their demand variability.

Categories:
X: Items with constant and predictable demand.
Y: Items with moderate demand variability.
Z: Items with high demand variability.
Purpose: Helps tailor inventory management strategies to the characteristics of different demand patterns.

2. VED Analysis:

Criteria: Classifies items based on their criticality to business operations.

Categories:
V (Vital): Critical items with a high impact on operations.
E (Essential): Important items but not as critical as Vital items.
D (Desirable): Items that are desirable but not critical.
Purpose: Prioritizes items based on their criticality, guiding resource allocation and risk management.

3. FSN Analysis:

Criteria: Classifies items based on their consumption rate.

Categories:
F (Fast-moving): Items with a high consumption rate.
S (Slow-moving): Items with a moderate consumption rate.
N (Non-moving): Items with low or no consumption.
Purpose: Guides inventory management strategies based on the movement speed of items.

4. HML Analysis:

Criteria: Classifies items based on their unit price or cost.

Categories:
H (High): Items with a high unit price.
M (Medium): Items with a moderate unit price.
L (Low): Items with a low unit price.
Purpose: Helps in setting appropriate control measures and order quantities based on the value of items.

5. SDE Analysis:

Criteria: Classifies items based on their supply and demand characteristics.

Categories:
Scarce: High demand and low supply.
Difficult: High demand and high supply.
Easy: Low demand and high supply.
Purpose: Helps in determining the appropriate stocking levels and reorder strategies.

6. Multi-Criteria Analysis:

Criteria: Combines multiple criteria, such as demand, value, criticality, and storage requirements, to create a comprehensive classification system.

Categories: Items can be classified into multiple categories based on the combination of criteria.
Purpose: Provides a nuanced and tailored approach to inventory management.

Example of ‘Inventory Classification’

For example, talking about a computer manufacturing line, the parts and software are all categorized as per their own importance…