As the APICS Dictionary can attest, there’s a whole alphabet of strategies to guide supply chain operations. At the start of the alphabet, ABC classification guides inventory management. The relatively simple yet effective concept splits a collection of items into three groups — A, B and C — based on item and dollar volume. The A group usually represents the top 10-20% of the items based on sales popularity, which tend to make up 50-70% of the collection’s sales volume. The B group contains the next 20% of items by popularity and dollar sales volume. The C group contains the remaining 60-70% of the items, which account for 10-30% of dollar sales. Items in the A group tend to be given more attention. For example, they may be counted more often to help avoid stockouts. Items in the C group tend to be governed by looser controls.

Although ABC classification or analysis has been associated with always better control, the method does have its limitations. For example, classifying items based on one or two factors could be too simplistic. In a dynamic marketplace, product sales can be erratic, which can cause items to switch groups quickly and frequently. If supply chain managers don’t stay on top of these frequent changes, their ABC classification could quickly become obsolete. Plus, these changes can have trickle-down effects on production, safety stock, service-level agreements, sales and marketing plans, and more.

ABC analysis can be improved by pairing it with XYZ analysis, a framework that classifies products based on their amount of demand variation. Like ABC analysis, XYZ analysis classifies products into three groups based on their level of demand predictability and how much they deviate from their forecasts:

• X items are ordered frequently, perhaps daily. With frequent replenishment, they should have low demand variation that is predictable.
• Y items are ordered less frequently, such as every few weeks or less. There is more variation in the demand amount.
• Z items orders are infrequent and irregular. They have the most demand variation and are the most difficult to predict.

The 9-box approach from the Association of International Certified Professional Accountants (AICPA) pictured below illustrates the ABC-XYZ relationship. 

Figure 1: The 9-box approach to the ABC-XYZ relationshipSource: AICPA, cgma.org

A company should never be out of stock on Class AX items. By comparison, class AZ items likely would not be inventoried because they could result from a large one-time purchase. Class CZ items are inventory liabilities.

A blended effort

With the combination of ABC analysis to consider item value and XYZ analysis to factor in demand variation, inventory managers can then collaborate with other key functional managers in production, accounting, information technology, logistics and procurement. The departments should all work together to both establish inventory management policies and develop systems and processes to implement these policies. AICPA suggests that these inventory policies could include

• degree of automation and timing of replenishment processes
• mutually agreed upon inventory parameters for ABC items, including buffer stocks
• inventory control rules, such as cycle counting frequencies.

Figure 2: ABC-XYZ policies

Source: AICPA, cgma.org

With this foundation, the combination of ABC analysis and XYZ analysis delivers three key benefits:

1. It provides a scientific and transparent framework to develop and refine inventory management policies.
2. It optimizes trade-offs among the costs, risks and benefits of holding stock.
3. It breaks down silos within an organization. Key stakeholders’ needs are known and can be factored into the inventory policy.

In addition, it better tailors inventory systems and procedures to corporate objectives or the APICS Supply Chain Operations Reference Digital Standard. 

Beyond the basics

This partnership between ABC classification and XYZ analysis is only the tip of the iceberg. There still are many other inventory management challenges that need to be addressed in day-to-day operations:

• What’s the best way to classify and manage a fast-moving, high-value item that is mainly purchased by one customer without a purchase agreement? What happens if that customer no longer needs that item?
• Is it accurate to classify a high-value item that is only sold once a year but in a large amount as a class A item?
• How can a global company manage items that are class A items in one country but not even on the radar in another country?
• What’s the best way to classify and manage a new product? Some managers choose to assign an L classification to these items at launch and manage them with special product-launch criteria through the initial sales cycle. Others might use the B classification as the middle ground of ABC classification.

In tackling these challenges, some companies might find that ABC classification and XYZ analysis are enough to create a working inventory management system. For more complex cases, other strategies might need to be considered or interwoven into the system. Perhaps the answers lie somewhere among the remaining 20 letters of the alphabet.