ABC Analysis: How to Categorize Your Inventory

Inventory is critical but expensive.

In fact, it’s the biggest expense when it comes to running a business. 69% of merchants surveyed last year used funding through Shopify Capital to buy inventory.

But US retailers currently are sitting on about $1.50 in inventory for every dollar of sales they make. That’s a lot of tied-up expenses—and making too big an investment runs the risk of dead stock. Getting inventory management right really can make or break your business.

There are many tools and strategies you can use to analyze your best and worst performing inventory, letting you optimize your investment and increase profitability. One place to get started is with an ABC analysis by product.

What is an ABC analysis?

ABC analysis is a data analysis technique you can use to identify your best and worst performing inventory over a certain period of time. In other words, it gives you greater inventory control by helping you identify the products that make your business the most money and the ones that cost your business the most money. This also helps you boost profitability. (In Shopify, you’ll see your best and worst performing inventory for the past 28 days.)

ABC analysis is based on the Pareto principle, or the 80/20 rule, and classifies your inventory using three categories based on total revenue:

• A grade. This is your best performing inventory, the money maker. A grade represents the specific inventory—in many cases only a small percent of the total—that accounts for 80% of your revenue. This is your most valuable inventory and should be protected and prioritized as much as possible.
• B grade. B grade is your middle-of-the-road inventory and should be treated as such. This grade represents the specific inventory that accounts for the next 15% of your revenue. B grade can often fluctuate between an A grade and C grade.
• C grade. And then you have your worst performing inventory. C grade represents the specific inventory that accounts for the remaining 5% of your revenue. You might also call this slow moving or dead stock. C grade brings very little value to your business and should be deprioritized as much as possible.

Here’s what that looks like with a hypothetical example:

Product	Revenue (28 days)	% of Revenue	Grade
Serving bowl	$50,000	50%	A	80%
Serving tray	$30,000	30%	A
Serving utensil set	$8,000	8%	B	15%
Salad bowl	$4,000	4%	B
Cutting board	$3,000	3%	B
Plate set – large	$2,000	2%	C	5%
Plate set – medium	$1,500	1.5%	C
Plate set – small	$1000	1%	C
Mug set	$300	0.3%	C
Glassware set	$200	0.2%	C
TOTAL	$100,000

Serving bowls and serving trays are the A grade products—this merchant would want to make sure they always have these products in stock. Plate sets, mug sets and glassware sets, on the other hand, make up the C grade products. The merchant might consider no longer carrying those items, improving the products themselves, or running extra promotions. We’ll share more ideas on what to do with A grade and C grade products in a bit.

The importance of ABC analysis

Optimizing your investment in inventory is a challenge for any business. It’s difficult to know which products to purchase so you can meet future demand without having an excess of leftover stock. Likewise, it’s nearly impossible to know which products to avoid when you’re purchasing blindly or based on intuition.

Optimizing inventory means striking a balance between having products available and minimizing the cost of inventory. Selling out of in-demand products could mean missing future sales—disappointed shoppers will likely seek items from your competitors, where they may become repeat customers. All together, retailers miss out on $1 trillion every year due to stockouts alone.

But you don’t want to buy too much—keeping dead or slow moving stock is a drain financially. Warehouse space costs more than $6/square foot, so it’s important to make the most of it. Unnecessary holding costs in the form of warehousing, insurance, and labor suck money from your bottom line. And when perishable products expire, there’s no salvaging them, even at discounted rates.

Businesses need to regularly analyze inventory if they want to ensure long-lasting success. And ABC analysis is one of the many ways you can do that. It’s easy for Shopify merchants—just go to the reports section in your dashboard to pull an ABC analysis by product report.

A grade strategies: what to do with your best performing inventory

You can apply many strategies to A grade inventory items to maximize your sales and profits. A items are easily identified using the ABC report in Shopify or with Shopify’s advanced inventory management app for brick-and-mortar merchants, Stocky by Shopify.

Create strong relationships with A grade suppliers

Business is built on relationships, and that doesn’t stop when it comes to your suppliers. Creating a strong supplier relationship can be very beneficial to your business in a number of ways.

For starters, your supply chain and reordering process will be more efficient. As the relationship with the supplier develops communication improves and both sides have a better understanding of how each other’s business operates. Suppliers will know who they’re manufacturing products for, and merchants will better understand the manufacturing process on the supplier side. This helps mitigate any delays in the supply chain.

Plus, if you’re easy to work with, you may also benefit in other ways—better pricing, quicker turnarounds, and other preferential treatment. A more enjoyable working experience for you and the supplier is always welcome.

Want to know how to improve your supplier relationships? Here are a few tips to keep in mind:

• Make sure you’re clear on what you want to order. Discrepancies could cause headaches for you and your suppliers.
• Put your order in writing. Create and send purchase orders so everything is documented and all parties stay on the same page.
• Don’t be shy. Share relevant information about your business so your supplier knows who they’re serving and can serve you better.
• Always pay on time. This should go without saying, but on-time payments also build a good reputation for your own business.
• Get to know your supplier’s business. Learn about your supplier’s business so you can give adequate lead time and build empathy around their own limitations.
• Connect on a personal level. Remember, all businesses are founded and run by humans.

Identify multiple suppliers for A items

While you want to have a positive relationship with your supplier, that doesn’t mean you can’t shop around and pursue other options as well. In fact, it’s critical to establishing a resilient supply chain, which is important for category A products—especially when it comes to preventing stockouts of your top performing items.

Suppliers can run out of manufacturing capacity if they face unexpected or uncontrollable circumstances, like too many purchase orders, manufacturing maintenance mishaps, or equipment breakdowns. These challenges can increase prices, which also negatively impacts your profit margins. And in a worst case scenario, your supplier could go out of business or discontinue the products you need, leaving you left to scramble for a replacement.

That’s why you want to reinforce your supply chain by identifying multiple suppliers, or at least a back-up supplier, for all your A grade products. It’s always a good idea to have a backup supplier to protect your supply chain and reduce the risk of costly stockouts.

Always have A grade inventory on hand

Recall that stockouts cost retailers nearly $1 trillion in sales in a single year. It’s critical to ensure you always have A grade inventory on hand, as it represents your highest performing and highly demanded products. That means lots of shoppers will seek you out for that exact product, and if you don’t have it, that leaves a bad impression. Worse, they might have to look elsewhere.

This is where safety stock comes into play. Safety stock is a small surplus of inventory you keep on hand in case you experience a change in market demands or lead times. You can calculate safety stock in a number of ways—the best approach depends on your business. Market variability, supply chain reliability, and the inventory carrying cost you’re willing to hold all impact the amount of safety stock required.

Here’s the basic formula for calculating safety stock for your A grade inventory:

You can pull all these metrics directly from Shopify. To determine the max daily sales, use the Sales over time report and the “variant” filter to determine daily sales for the unit you want to calculate the reorder point for. From this view, you’ll be able to determine the maximum daily sales over a specific time period.

The average daily unit sales refers to the number of units you sell of a particular product over a specified period of time. To determine this, refer to the Average inventory sold per day report in Shopify.

The average delivery lead time is the amount of time it takes to receive a shipment of stock. To get this, divide your total number of lead times by a set period of time.

This merchant knows that the longest they’ve had to wait for a purchase order was 15 days, but on average it takes 10 days to receive “serving bowls” from their supplier.

Therefore, the safety stock for this merchant is:

safety stock = (5 x 15) – (10 x 1.5) = 60 units

Identify a reorder point for A grade stock

Once you know your optimal stock levels for A grade inventory, you can identify a reorder point for those products. Knowing the reorder point allows you to prevent stockouts and even automate the purchase process.

The reorder point is essentially a simple calculation that lets you know the lowest amount of inventory you can sustain before you need to order more in order to maintain the optimal stock level. You can calculate the reorder point for each individual product (or variant) that you sell.

Here’s the reorder point formula:

Using the same example above, this merchant’s reorder point is:

reorder point = (1.5 x 10) + 60 = 75 units

In Shopify, use the Month-end inventory snapshot to monitor your inventory quantities for A grade products. Once your product or variant quantity hits the reorder point (i.e., 75 units), you know it’s time to order more products.

Invest more in A grade inventory

Since your A grade inventory is your top performing stock, it’s likely a good idea to invest more in these products, especially if demand is steady and sustainable. In some cases, you might order higher quantities of inventory from your suppliers so you have more to sell. Or, you could increase your marketing and advertising spend on A grade products to drive more demand and sales.

Increase prices for your A grade inventory

Pricing products is a challenge in itself and many variables need to be considered. Things like target audience, cost of products, revenue targets, competitor pricing, seasonality, and knowing where the market is headed.

But given demand is highest for your top performing inventory, you may want to consider raising prices slightly in order to increase your profit margin. Take a look at your pricing strategy for A grade products to see if shoppers would be willing to pay more so you can improve your bottom line.

Secure and control A grade inventory

A grade inventory is high performing and highly coveted and it should be treated and protected as such. This means placing better security and control over your A grade stock to ensure it stays safe and pristine so you can sell it.

Unfortunately, products are damaged, misplaced, and even stolen. To prevent this from happening to you, consider the following ideas:

• Secure this inventory with multiple locks, security guards, and other safety measures, especially if you use your own warehouse or keep your inventory at home.
• Monitor A grade stock with a security system and video surveillance. 3PLs likely already have strong security precautions in place.
• Conduct cycle counts on a regular basis. This will help you detect discrepancies early.
• For inventory in retail locations, you can use security tags, electronic article surveillance (EAS), cameras, merchandising security, and more.

C grade strategies: what to do with your worst performing inventory

You can also use many strategies to optimize your C items, helping you reduce costs and free up cash. C grade products are essentially dead weight. In fact, 60% of supply chain professionals claim that their priority is to reduce inventory expenses.

Generally, your best bet is to “get rid of C” so you can limit the financial burden of keeping it on the shelf. C grade products take up space in your warehouse and prevent you from purchasing A grade products, which are the products your customers actually want.

Reduce the price or sell C grade products at a discount

While you raise prices for A grade products to maximize profitability, you want to consider lowering prices for C grade inventory items to get them off the shelves. Many shoppers, especially online shoppers still make purchasing decisions based on the lowest price. Lower prices could make your C grade products more attractive to buyers.

By reducing your price to be lower than your competitors’ or even offering the product at cost, you’ll save more money in the long run. Essentially, you’re better off selling the inventory than worrying about your profit margins. The longer you hold onto it, the longer it costs your business.

Give your C grade products to charity

Philanthropy is great from both a human and a business perspective. On one hand, you’re contributing to a cause and making the world a better place. On the other, you’re giving customers a more compelling reason to support your brand and buy your products. One CSR survey by Cone Communications found that 87% of consumers claim they’ll purchase a product because a company supports an issue they care about.

This is a strategy that can work well for C grade products, giving shoppers an extra incentive to buy. In addition to donating proceeds to charity, you can also donate actual products to those in need. If you need ideas for a cause to support, look for local charities that would specifically benefit from your slower moving inventory.

Bundle dead stock products with A grade or B grade products

Product bundles are when you group together multiple products for a single price. This works well because many buyers like to feel they’re getting a deal. When you bundle complementary C items with A or B items it gives shoppers the perception and feeling that they’re getting more bang for their buck.

As a result, demand for those C grade products increases, you can sell it at a slightly higher price, and you get rid of your dead stock, all at the same time. By pairing a C grade product with a top performing product, you’re also improving the buy rate of your bundled A and B grade products.

Increase visibility for your C grade inventory

Sometimes C items just need a little bit of attention. Giving your C grade products more visibility online and in your brick-and-mortar store can increase visibility, in turn driving more demand and sales.

Consider placing C grade items next to complementary A grade merchandise, or strategically displaying it in the checkout line or other highly visible and trafficked locations in your retail store. You can also run online marketing campaigns to promote your C grade products.

Learn more: How to Move Your Brick-and-Mortar Business Online

Give away your C grade products as gifts

While shoppers like a deal, they like free even better. Everyone loves a free product. Plus, online shoppers are more likely to pay for a product that has something included for free.

Giving C grade products away to customers as freebies gives you the chance to offload excessive inventory, while also creating an enjoyable and memorable experience for your customers. You can even give away your C grade products to your top customers as a way of recognizing and thanking them for their business. These tactics can lead to increased loyalty and repeat purchases.

Discontinue and stop ordering C grade inventory

When all else fails, C grade inventory is likely a candidate for discontinuation. Unless your product serves another purpose for your business, consider removing that product from your store so you can focus your investment on better performing products.

Shortcomings of ABC analysis

While ABC analysis is incredibly valuable for merchants who want better inventory control, it does have a few downfalls.

• It doesn’t account for seasonality. Seasonality complicates the process. For example, toys may be considered C grade through the summer and fall, but sales typically skyrocket for the holiday season, when they become A grade or B grade products.
• It doesn’t account for changing consumer behavior and trends. Trends can impact how and what buyers shop for during a period of time. These trends shift over time, so historical data isn’t always reliable for forecasting.
• It doesn’t account for new product launches. If you’re launching a new product, you likely won’t have historical data to predict that product’s performance. You need to collect at least a few months of data to know if it will be a top selling product for your store. With ABC analysis in Shopify, you can filter out new products from the report for a more reliable analysis.
• It’s one of many metrics you should consider when making inventory decisions. ABC analysis is based on inventory retail value, as opposed to frequency of sale or the movement of that variant, which are also important inventory metrics. When using analytics in your business, it’s always important to consider multiple sources and the bigger picture.

Optimize your inventory with Shopify

ABC analysis is a helpful way to see which products perform best and worst so you can optimize for sales and profitability. It’s easy to get started with ABC analysis by product in Shopify.

If you’re a brick-and-mortar merchant looking for more advanced inventory management capabilities, check out Stocky by Shopify.

Illustration by Rachel Tunstall

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