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Organizations utilizing supply chain management or the 5S Methodology rely heavily on inventory controls to keep processes running smoothly, but there are times when an ABC analysis doesn’t work for some businesses due to its classification system based on sales.
When an organization utilizes the ABC system they look at unit sales and revenues per year to determine when and what to restock in a timely manner. For example, a car dealership utilizing the ABC system can efficiently see what types of cars, accessories or parts sell most often and keep them on hand at all times; and other low selling parts or specialized inventory can be ordered when needed or on appointed stock days when bulk discounts are offered.
Basically, an ABC analysis categorizes inventory as either A, or high-selling inventory making up 80 percent of total sales; B, 15 percent of your total annual sales; and, C, or inventory consisting of 5 percent of total sales.
This simple method of keeping the right inventory on hand when needed often, however, doesn’t work for some inventory purposes.
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Where It Won't Work
Some cases where an ABC method won’t be effective include:
Custom Homes – A general contractor specializing in custom home building may be unable to determine what sort of inventory will be needed. Only when they meet with architects and homeowners will they be able to realize the type of materials needed. Will the home be built with brick, wood or stone? Because custom homes must meet the desires of the new occupants, it’s often hard to determine the amount of plumbing services and even hardware needed for the home until the size and homeowner's desires are discovered. On the other hand, a woodcrafter may be able to use an ABC analysis when determining types of wood to keep on hand based on prior popularity.
New Businesses – Whether it’s a gift shop or any type of retailer, only when the business has some sales revenue history behind it will the ABC method be relevant. If one guesses and plans on selling many items, it’s impossible to determine consumer favorites, wants and needs of the target market. Retailers with history can base sales revenues to determine inventory categories.
Jewelry – Owning, running and creating jewelry—especially custom piece--is also another area where this method may not work. A jeweler may know they should keep certain gems on hand or certain amounts of gold, silver or platinum, but keeping too much on hand could tie up cash as this business fluctuates and is often seasonal. For example, a jeweler with too much inventory and no customers has all of his assets tied up awaiting custom orders.
Seasonal – Retailers who sell seasonal items such as party or wedding supplies or offer services depending on the season can rely on past history; however, the general economy must be considered prior to ordering inventory. Again, these types of businesses fluctuate and often depend on tourism, cancelation of events or other unforeseen elements. Again, too much inventory ties up cash flow and bad inventory management can make or break your business.
The Inexperienced – If one buys an existing business with no background experience on the type of business—even if it’s a restaurant where favorites should be easily identified--the lack of experience may make an ABC analysis impossible. Guesstimates are not part of the science of this inventory method and, again, the inexperienced will end up with product they can’t sell or return.
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When an ABC analysis doesn’t work for some companies, there are other methods to utilize including FIFO, or first in last out and LIFO, or last in first out. These methods are useful especially on the company’s balance sheets as they consider the cost of goods sold, when they are sold and how many remain at the end of the accounting period.
A company can also use the average cost method by determining average costs on total inventory units. This method is also known as rolling average cost method or the weighted average cost method and also works well for determining average dollars contained in existing inventory.
Finally, the small business owner should take a look at inventory tracking software to aid them in not only keeping the right inventory on hand but also determining the not-so-popular. Many companies offer such software at different pricing levels based on company needs.
Because inventory is a big part of any business, it should not be taken lightly or all of your cash may be spent on the wrong inventory and you’ll end up with obsolescent items you can’t sell or return.