Many enterprises experience a substantial variance in profitability and volume across product lines. If no restrictions are applied, a firm may find that less than 20 percent of all products marketed account for more than 80 percent of total profit.
Based on Pareto analysis which says 20% of the items contribute to 80% of sales. It implies that a small portion of items in Inventory contribute to maximum sales. Typically less than 20% of items classified as ‘A’, contribute as much as 80% of the revenue. The next 15% (80% – 95%) contribution to revenue is done by ‘B’ class Items. The last 5 % revenue is generated by items classified as ‘C’. As the classification is done according to the importance of their relative value, this approach is also known as Proportional Value Analysis (PVA).
With the 80/20 rule, or Pareto principle, management must avoid such outcomes by implementing inventory strategies based on broad-line product classification. A sensible estimation of the incremental value added by stocking low-volume or low-profit products is essential in reducing excessive inventory.
Some high value items classified as ‘A’ in terms of value of transaction but may be very inconsistent in terms of demand. The items get classified as ‘A’ for the only reason that their unit rates are so high that even few transactions can amount to substantial value and hence result in classification of these items as ‘A’ class items. For such highly inconsistent items classified as ‘A’, common inventory management techniques like Minimum Order Quantity, Re-order Levels etc may not be applicable. Similarly some very low value items may have a steady and constant demand. Because the unit prices are so low that even large transactions may render these items as ‘C’. Therefore, for efficient material management purposes, a two dimensional approach is recommended
In one dimension, inventory is classified based on the total value of transaction for specific period called ABC – Classification and in the second dimension inventory is classified based on the consistency of demand called XYZ – Classification. Items which have consistent demand are classified as X. Items which don’t have consistent demand are classified as Y and items with erratic demand are classified as Z.