What Is Item Stratification?
Item Stratification (also called “Item Classification”) is the result of a distributor’s efforts to classify inventory into categories that enable the company to stock the right item, in the right quantity, at the right location. In other words, this tool will not help decide which products should be put into stock, but it will help with the challenge of figuring out which items should remain in your inventory. It won’t take the place of forecasting, but does help with purchasing decisions. Proper execution of item stratification can have the following benefits for you and your organization:
- Increased fill rate
- Improved customer service levels
- Recaptured margin that was previously given to competition or other distributors
- Increased opportunities for reinvestment
- Improved EBITDA
Most companies stratify their items in some shape or form, but few apply more than a single or dual data point methodology. Stratifying the items that your company stocks can help create focus on the products that are currently carried and are doing well, versus the ones that have fallen into the “black hole” of slowmoving and dead inventory.
Where is Your Organization with Regard to Item Stratification?
How does your organization categorize inventory? Here is a simple reference matrix to determine where your company might be in terms of how you stratify.
Real World Example
In this real world example, a company classified its items using only two data points: cost and sales frequency. While this method does provide some foundation for determining how often a product is sold, the Unit Cost data point only provides the weight of the cost to buy the product. The picture is still incomplete.
When compared to what would be considered best practices, this method of item classification is a “Good” practice, but not “Best.” Inventory stratification that is based on just one or two data points does not fully account for all aspects of a business. Often, more than a single data point will be needed for the best results.
Industry experts with the Supply Chain Systems Laboratory and Industrial Distribution department at Texas A&M University1 have found through extensive research and analysis that Sales, Hits and Profitability (Gross Margin Return on Inventory Investment, or GMROII) all help attain the optimal solution for most distributors. Some companies may want to include more (or different) factors that apply to their specific industry or business environment (e.g., product lead time, product life cycle or expiration sensitivity, logistics costs, and so on). The combination method is shown below:
Implementing Inventory Stratification Best Practices
The first thing your organization needs to do is create a plan of attack; i.e., determine the process that will be used, which data points will be included, and what data is available for analysis to accomplish this.
For our purposes, we’ll take a look at only three data points, to help explain the process. Those data points are:
• Sales volume
• Hits (a.k.a. logistics or physical inventory movement)
The following table captures the rankings of each of the data points:
This is the method used by a majority of customers measuring a single data point(sales volume).
The GMROII data point provides clarity on the true profitability of items. To calculate the GMROII of an item, take the gross margin for the year and divide by the average inventory (expressed as dollars).
This method is defined as the frequency of the movement of product, regardless of the actual quantity being moved. (The Pareto methodology uses the Pareto Principle, also known as the “80/20 Rule”—the idea that 20 percent of causes generate 80 percent of results. The goal is to identify and prioritize the 20 percent of work that will generate 80 percent of the results that doing all of the work would deliver.)
Weighted ABC Matrix
The next step is to provide weights to each of the data points being used in the calculation. These weighted factors help the organization address factors that may be specific to your business or industry and assist with making fast decisions on an ABCD ranking.
Below is an example of a weighted matrix, providing a clearer picture of how items are classified using a three-factor, weighted combination method.
There are two more factors that need to be considered in determining the final rank:
- Weighted value given for each ABC Value Rank (traditionally split as A, B, C, D and 40%, 30%, 20% and 10%, respectively)
- Bucketing values for Final ABC Rank split (or % spread) to determine how many products to allow into each Final ABC Rank. For the purpose of this paper, we’re sticking with the industry experts’ recommendation of 25% for the spread.
With 1-4 serving as the scale from worst to best, here is the spread expressed as cumulative scores:
- A = 3.25 to 4
- B = 2.5 to 3.24
- C = 1.75 to 2.49
- D = 1 to 1.74
Provided below is a sample rank calculation showing how the math is done to come up with the Final ABC:
One might ask why a Final Rank is needed if the individual ranks have already been determined. The reasons are:
1. Final Rank separates the low volume/high profit items from the high volume/ moderately profitable items (of course, the latter should be the preference).
2. It allows the organization to easily keep its “bread-and-butter” items (the high volume/low profit items) from being classified as a C or D because of low GMROII scores.
3. Customer Service Levels are maintained through an ABC ranking.
4. Using a Final Rank reduces the work effort required to maintain and drive purchasing decisions.
How Often Should Stratifying Occur?
The effort of stratifying items may be too intense to complete monthly, yet conducting it annually may not be often enough. Industry experts typically suggest within the quarterly to every six month range. This allows the organization to remain agile and to capture changes in sales, GMROII, and hits.
Why Should My Organization Stratify?
Does your organization want more revenue? How about having the right item in the right quantity at the right place, after being purchased at the optimum price?
Here are details on the benefits mentioned earlier, and how item stratification can help get you there:
Increased fill rate
Along with replenishment and forecasting, item stratification helps to improve your organization’s fill rate. By stocking the items you’ve proven are effectively selling through conducting an inventory stratification, you are empowering the organization with the right inventory mix. By having fast-moving inventory, you are allowing your salesforce to go to customers and ask for more of their business. This leads to more inquiries, more purchase orders, more sales, and a higher fill rate. Improved customer service levels
Achieving optimal customer service levels involves balancing the cost of inventory against the cost of a stock out; this is one of the main criteria when determining safety stock. It is sometimes a difficult calculation to perform because capturing the stock out cost can become complicated. If a stock out occurs, the customer may decide to:
• Purchase a similar product in your inventory
• Postpone the purchase until stock is available
• Purchase from a competitor
There are internal costs for stocks outs, as well. A few of them are as follows:
- Purchase from the supplier on a rush (with an increased cost), often not passed on to the customer
- Purchase from a fellow distributor (usually at a mutually reciprocal price, but still a reduced margin at the end of the day)
- Purchase from a competitor that has it in stock (and they say, “Thank you for the business”)
Increased opportunities for reinvestment
Once an organization has stratified its inventory, it must then make decisions on how to reduce the slow-moving or dead inventory (in the C and D categories). This can be done through a multitude of avenues:
- Reduce the sell price
- Deploy a dead stock team to scour the sales history and new quotes for opportunities to offload inventory
- Incentivize the entire organization by splitting profit, kicker bonuses, or other financial “carrots”
- Ask suppliers to exchange inventory for faster-moving product (They’re usually keener to this than an outright return.)
- Join inventory sharing associations
- Donate inventory to technical or training programs. It’s a tax write-off and a marketing tool
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), simply put, is an organization’s net income with all the interest, tax, depreciation, and amortization added back in. It’s commonly used to analyze a company’s overall profitability completely independent of financial or accounting factors.
As an organization frees up cash that is locked into dead and slow-moving inventory and reinvests it into A and B items, the opportunity for sales will increase (though the total inventory value won’t change). Increased turns allow the company to make profit on that same inventory investment multiple times as the product is replenished over the course of a year. More sales with the same inventory value (but with more profit) affect the bottom line, which will have a direct impact on your organization’s EBITDA.
One challenge that comes up with many multi-branch locations is whether they are stocking an item in the right quantity at the right location. It’s important for these multi-branch enterprises to conduct a secondary ranking class to determine the global ABC Rank and compare it to each of the local branches. Below is a matrix of different inventory distribution approaches that can assist a company in making decisions at an enterprise level.
Not to be Confused with Dual Criteria Method
A concept that is becoming more common within the industry is that of product placement. This too involves an ABCD methodology (referred to by industry experts as a dual criteria ABC method), but it can be (and often is) different than the item stratification described here. The product placement methodology is focused on reducing the number of steps and travel time taken by pickers to complete an order. The dual criteria method is based on frequency and hits of product picking and should be addressed as a separate topic.
Through the use of a strategy that combines multiple data points (e.g., profit, sales, and hits), a distributor can capture more accurate rankings and make sure the profitable and high volume items are ranked as ‘A’ and that some low or medium profitability items are still ranked ‘A.’ This is, of course, dependent upon the generation of sufficient sales volume.
Many distributors put items into stock because a customer or a salesperson “sandbagged” the demand or overstated the true requirements. Item Stratification will help your organization keep the right items in stock, while identifying opportunities of slow-moving and dead inventory to scrap, write-off, or market at reduced/special rates to customers. The end goal should be to reinvest the freed cash into inventory that does turn, thereby improving your organization’s bottom line.