When I talk to a client, they often refer to their “A” items. That is, those items that are most important to have available for immediate delivery or use. When I ask them how they identify “A” items, the most common response is total cost of goods sold recorded over the past 12 months. That is, those items with the most dollars flowing through inventory. A typical ranking strategy identifies “A” items as those responsible for the top 80% of cost of goods sold, “B” items as those responsible for the next 15% of cost of goods sold and “C” items responsible for the last 5% of cost of goods sold.
But is cost of goods sold the best way to classify your critical or most important products? You might stock a relatively inexpensive item that is frequently requested. While annual cost of goods sold is relatively low, customers order it several times a week. Isn’t it important to be sure that this item is always available?
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 will apply the same percentages (i.e., A = the top 80% B = the next 15% and C = the last 5%) to all three criteria. Over the next several months we will examine how “three-way ranking” can maximize the productivity and profitability of your investment in stock inventory. Let’s start this process by looking at a couple of examples.
The first product is “A” ranked based on cost of goods sold, “A” ranked based on frequency of request, 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.
There is nothing wrong with cost of goods sold ranking. It is a useful tool to identify those items whose inventory should turnover most often. But it should not be the only criteria for analyzing your inventory. Next month we will continue our discussion of how using three ranks will ensure that all of your inventory is profitable or contributes to other profitable sales. And in April, we will explore situations where you must maintain a nonprofitable item in inventory to achieve your desired level of customer service.