Inventory Segmentation Approaches



Inventory Segmentation Approaches

In my previous article I raised the point that many companies use a ‘one size fits all’ approach to inventory strategy. This tactic will result in excess inventories or imbalances in inventory coverage and service.  This article outlines three common approaches to inventory segmentation: ABC, XYZ and combined ABC/XYZ segmentation.

ABC Segmentation

Traditional inventory ABC analysis classifies ’A’ items as most important, and ‘C’ items as least important. Importance can be defined in several ways such as volume, revenue, margin, or cost. We prefer to use a ‘contribution’ definition such as revenue or margin as some high-volume items might only be classed as a ‘C’ item based on margin. ABC analysis is similar to Pareto’s 80:20 principle in that ‘A’ items typically account for a large proportion of overall value but a small percentage of the number of items.

In addition to contribution criteria it is also helpful to consider frequency of movement and agree a frequency of movement threshold below which (despite overall contribution) the item would be classified as a ‘D’ item (a Make to Order or a ‘Non-Stock’ item). What determines an appropriate movement threshold will vary by industry sector. The over-ruling criteria for stocking or not stocking an item should be dictated by the competitiveness of the market and customer lead time expectations.

XYZ Segmentation

XYZ segmentation is used to segment inventory based on variability in demand rather than volume, cost, or contribution. ‘X’ = low variability in demand and ’Z’ = high variability in demand. Co-efficient of variation is a common approach to measuring variability but an alternative measure to use ‘forecastability’ of an item or the level of forecast error. Some items with large variation can be forecastable e.g. items with seasonality so forecast error is often a preferred measure of variability. In XYZ segmentation X items are characterised by steady and very predictable demand, Y items are less stable but relatively predictable and finally Z items are very unstable and unpredictable. The implications of this segmentation approach are that X items are typically easier to forecast and therefore will require less inventory coverage whereas Y and Z items are harder to forecast due to their variability and therefore will require more inventory coverage.

ABC + XYZ Segmentation

Both ABC and XYZ segmentation methodologies have their merits for inventory classification, but best practice is to use both methods in combination. First carryout an inventory ABC analysis and then review items in terms of variability or your organisation’s ability to forecast the items accurately. Items can then be categorised as follows:

 AX / BX items contribute significantly, and demand is very stable, so the risk of shortages is low. Inventory coverage can therefore be maintained low.  These items whilst very important will require least time and effort in terms of management.

CX items have low variability but also low contribution. These items also require little intervention as demand is steady, however, the contribution from these items should be regularly reviewed.

AZ items provide significant contribution but are highly variable and difficult to predict or forecast. Larger inventory coverage will be needed to allow for the level of uncertainty. These items will require more time and attention and more frequent review in terms of demand and supply planning.

CZ items contribution is low, and demand is very unpredictable or difficult to forecast. This segment will certainly contain Slow Moving / Obsolete items and holding inventory of these items should ideally be avoided.

Summary

The one-size fits all approach to inventory strategy will result in carrying excess stocks and or an imbalance in coverage across your inventory portfolio. This article has outlined the three most common approaches to inventory segmentation. Our recommendation is to at least implement an ABC segmentation and embed a regular and formal process to review and categorise your inventory.

For more information on Inventory optimization or if you would like to know how we can help, visit our site  www.optimized.org.uk

Stewart Williams, Partner at Optimized Supply Chain Solutions.


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