Inventory Segmentation



Quick Guide on Inventory Segmentation Approaches

In my previous article, I highlighted the pitfalls of adopting a 'one size fits all' approach
to inventory strategy, emphasising the importance of tailored segmentation to optimise
inventory management. In this article, I will delve into three common inventory
segmentation methodologies: ABC, XYZ, and combined ABC/XYZ segmentation.

ABC Segmentation

Traditional ABC analysis categorizes items into 'A', 'B', and 'C' classes based on their
significance, often measured by volume, revenue, margin, or cost. I advocate for using a
'contribution' definition, such as revenue or margin, as it captures the true value of each
item. Typically following the Pareto Principle, 'A' items represent a large proportion of
overall value but constitute a small percentage of the total number of items.
In addition to contribution criteria, considering the frequency of movement is beneficial.
Establishing a movement threshold below which an item is classified as a 'D' item
(Make to Order or Non-Stock) can aid in efficient inventory management. The decision
to stock an item should be guided by market competitiveness and customer lead time
expectations.

XYZ Segmentation

XYZ segmentation focuses on variability in demand rather than volume or contribution.
'X' items exhibit low demand variability, while 'Z' items display high variability. Variability
can be measured using the coefficient of variation or forecast error. X items have steady
and predictable demand, Y items are less stable but relatively predictable, and Z items
are highly 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

Combining ABC and XYZ methodologies provides a comprehensive approach to
inventory classification. Initially, conduct an ABC analysis to identify high-value items.
Subsequently, assess items based on demand variability to categorise them effectively:

  • AX/BX: High-value items with stable demand, requiring minimal inventory
    coverage.
  • CX: Items with low variability and contribution, requiring periodic review.
  • AZ: High-value items with unpredictable demand, necessitating larger
    inventory coverage.
  • CZ: Low-value items with unpredictable demand, ideally avoided in inventory
    holdings.

Summary

Adopting a tailored inventory segmentation approach is crucial to avoid excess stocks
and coverage imbalances. Implementing at least an ABC segmentation and establishing
a formal process for inventory review and categorisation is recommended.


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