Enterprises operate in conditions of strong market competition, and in order to achieve profits, they use increasingly sophisticated methods, implement Lean culture or Sales & Operations Planning, and strive to seek savings at every stage of the supply chain. One of the tools that allows for a universal way of dividing time and resources proportionally between the most profitable products and those generating minor benefits is ABC classification. The purpose of this article is to propose how, using a spreadsheet, one can manage a portfolio by diversifying activities related to planning and control.
Definition of ABC classification and the associated Pareto principle
ABC classification is a classification of inventory sorted in descending order based on annual volume, profit, storage costs, or other criteria. This set is divided into three classes, called A, B, and C. The most popular division was made based on the 80:20 Pareto principle. The Italian economist Vilfredo Pareto, based on his observations, concluded that usually a small number of elements generate the results achieved in any situation. The Pareto rule states that 20% of inventory/products generate 80% of costs/profits/revenue. This rule is successfully applied in many fields of science and life. Based on it, the ABC classification was also created; this is illustrated in Table 1, where category A is assigned 20% of items, which account for 80% of annual revenue, category B is assigned the next 30% of inventory, which accounts for 15% of revenue, and category C contains the least profitable 50% of products, which generate only 5% of revenue. In summary, class A products are the most important in the portfolio and should be given the most attention, unlike category C. The classification is created so as not to treat all products with the same commitment of time and resources. Such a classification was created at the Carlsberg Group. A distinction was made between products that are the engine of the organization and those that constitute the so-called tail. Such a division allowed for streamlining decision-making, setting priorities in operational activities, as well as the sequence in implementing supply chain processes in the newly created company – the supply chain headquarters, where purchasing, production, planning, and logistics processes are supervised for breweries throughout the Group. For example, Sales & Operations Planning meetings began to focus on discussing the development, promotion, forecasts, and maintaining a safe storage level for class A products, rather than all products in the portfolio. Previously, when there was no product prioritization in the organization, the entire portfolio was discussed at S&OP meetings without properly delving into the essence, unnecessarily wasting time also on the least profitable products (here: 50 products that bring 5% of profits).
Steps necessary for determining ABC classification
Every organization is unique, has its own specifics, and therefore, based on general principles, one must approach the division of products into classes A, B, and C individually. First, it is necessary to determine the characteristic elements that influence the results of supply chain management and around which the ABC analysis should be conducted. Criteria can be different. There are organizations that pay the most attention to volume or revenue. In the author’s opinion, a better criterion is profit, because this financial figure shows the actual impact of a given product on the profitability of the organization as a whole. Establishing an ABC classification in terms of volume creates a risk that products that are sold the most will be qualified for class A, which does not mean that they provide the highest profit, because the margin on these products may be negligible. An example is products dedicated to large retail chains, whose unit margin is often minimal; manufacturers wonder if the total profit is high enough to keep such products in the portfolio, because the opportunity cost is blocking production lines whose capacities are limited, and on which one could produce products with higher profitability at the same time.
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Source: Logistyka Magazine