Understanding How You Rank Products
By Matt and Jon Schreibfeder
Ranking is the process of classifying your products. We just received an email from a distributor asking what percentage of their inventory dollars should be invested in “A” ranked products? They were surprised that there was no simple answer. We needed more information.
First, what is their criteria for an “A” ranked product? They couldn’t provide a definite answer. After doing some analysis we discovered that they were ranking products by the total cost of goods sold throughout the company. After sorting all items (both stocked and non-stock) in descending order based on cost of goods sold recorded in the previous 12 months, “A” items represented 80% of the total, “B” items represented the next 15% of the total, “C” items represented the next 4% of the total, and “D” items the last 1% of the total. Products ranked “X” experienced no sales and therefore had no cost of goods sold.
There are several problems with this organization’s ranking process:
- The distributor included both stock and non-stock products in the ranking process. Non-stock (i.e., special order) products are not meant to remain in inventory for an extended length of time. They should immediately be used upon receipt to fill an existing customer order. As product ranking is designed to be a measurement of stock inventory performance, it is best to exclude non-stock products from the ranking analysis as they may contribute to misleading results.
- Ranking was performed based on company-wide cost of goods sold. Product sales and other usage may vary by location within the company. Best practice is to independently rank products in each warehouse.
- Basing product rank solely on annual cost of goods sold may classify a very expensive item with a high annual cost of goods sold value, that has few orders and little profit, as an important “A” ranked product.
We suggested the distributor redesign their ranking process before using it making stocking decisions. Best practice is to rank or classify products based on three separate criteria:
- Cost of goods sold
- Frequency of sale or use (i.e., the number of times the product is requested)
- Profitability (i.e., annual gross profit dollars)
We use a “blend” of all three ranks to provide a comprehensive analysis of a specific item’s performance.
Let’s say a product is “A” ranked based on cost of goods sold, “A” ranked based on frequency of request or hits, but “C” ranked based on gross profit dollars. While this “AAC” ranked product gets high marks for two of the criteria, it presents a possible problem. The high cost of goods sold indicates that there is a lot of money tied up in inventory. The high frequency rank shows that customers are frequently requesting the product. The problem involves the profitability rank of “C”. The frequent sales aren’t resulting in a lot of profit dollars. Could your sale prices be so low that you are losing money on every transaction?
It would be better to have a product that is “C” rank based on cost of goods sold, “A” ranked based on frequency of request and “A” ranked based on profitability? That is a “CAA” item. The low cost of goods sold indicates that you have few dollars invested in inventory. However, customers frequently request the item, and you are making a lot of money on those sales (i.e., “A” ranked for both frequency and profitability).
As a result, we suggested the distributor invest the majority of their inventory dollars on high hit and high profit items. For those products that are high ranked in both categories, we want to be sure they have extra safety stock (i.e., reserve inventory) on the lower cost of goods products. It is relatively inexpensive to ensure these products against stockouts due to unusual usage or delays in receiving a replenishment shipment.
While ranking is a valuable tool for identifying problems and opportunities in your inventory, there is a problem. Often, we see a wide range in the values assigned to “A” ranked items and smaller ranges in the lower ranks. Here is an example from one of our clients:
Rank Cost of Goods Sold Hits Profit$
A $531,057 – $1,475 716 – 9 $106,211 – $295
B $1,474 – $276 9 – 3 $294 – $55
C $275 – $67 2 $54 – $13
D $66 – $.01 1 $12 – $.01
An “A” ranked item could have nine or 716 hits a year (12 months cost of goods sold of $1,475 to $531,057 or annual provide of $295 to $106,211). Most organizations would want to treat products that sold less than once a month (i.e. with nine annual hits) differently from product that sold more than twice a day (i.e., with 716 annual hits). While “C” ranked products that sold twice a year and “D” ranked products that sold once a year would be handled using the same stocking rules.
You will probably see similar results when you rank your inventory. There is a definite need to supplement cost of goods sold ranking with a more granular analysis of your most important products. Next month, we will explore a simple way to divide your “A” items into several meaningful classifications. Our goal is to provide you with a valuable tool to allow you to focus on those items that are most important to your customers, and contribute most to your profitability.