A Problem with Ranking Products

A Problem with Ranking Products
by Jon and Matt Schreibfeder

Most organizations want to focus their attention on the products in their inventory that contribute most to their success.  One way to do this is by ranking products.  Ranking is the process of classifying products based on activity.  There is an old adage that “80% of your sales will be generated by 20% of the products you stock”.  But we have found that this is often not true.  For many organizations, 80% of activity is generated by no more than 10% to 13% of stocked items.  And 95% of activity is generated by no more than 50% of products.  To be successful, you need to analyze the stocked products in your own organization.

Best practice is to rank or classify products based on three separate criteria: 

• Cost of goods sold
• Frequency of sale or hits (i.e., the number of times the product is requested)
• Profitability (i.e., annual gross profit dollars)

Ranking starts by sorting products in descending order based on each specific criteria.  Though the percentage of items assigned to each rank is subjective and varies by organization, the most common classifications are:

• “A” items are those items responsible for the top 80% of each criteria
• “B” items are responsible for the next 15% of each criteria
• “C” items are responsible for the next 4% of each criteria
• “D” items are responsible for the last 1% of each criteria
• “X” items have no activity

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?

Would it 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).  This is a product that you probably always want to have in stock.

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:

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 profit dollars 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 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 the those items that are most important to your customers, and account for the largest part of your investment in inventory.