Earlier, we showed how to develop inventory policies using quantitative techniques. There are also some very practical considerations that should be incorporated into the implementation of inventory decisions, such as ABC analysis.

The purpose of ABC analysis is to divide all of a company’s inventory items into three groups (group A, group B, and group C) based on the overall inventory value of the items. A prudent manager should spend more time managing those items representing the greatest dollar inventory cost because this is where the greatest potential savings are. A brief description of each group follows, with general guidelines as to how to categorize items.

The inventory items in the A group account for a major portion of the inventory costs of the organization. As a result, their inventory levels must be monitored carefully. These items typically make up more than 70% of the company’s business in dollars but may consist of only 10% of all inventory items. In other words, a few inventory items are very costly to the company. Thus, great care should be taken in forecasting the demand and developing good inventory management policies for this group of items (refer to Table 6.8). Since there are relatively few of these, the time involved would not be excessive.

The items in the B group are typically moderately priced items and represent much less investment than the A items. It may not be appropriate to spend as much time developing optimal inventory policies for this group as with the A group, since these inventory costs are much lower. Typically, the group B items represent about 20% of the company’s business in dollars and about 20% of the items in inventory.

The items in the C group are the very low-cost items that represent very little in terms of the total dollars invested in inventory. These items may constitute only 10% of the company’s business in dollars, but they may consist of 70% of the items in inventory. From a cost–benefit perspective, it would not be good to spend as much time managing these items as the A and B items.

For the group C items, the company should develop a very simple inventory policy, and this may include a relatively large safety stock. Since the items cost very little, the holding cost associated with a large safety stock will also be very low. More care should be taken in determining the safety stock with the higher priced group B items. For the very expensive group A items, the cost of carrying the inventory is so high that it is beneficial to carefully analyze the demand for these and set the safety stock at an appropriate level. Otherwise, the company may have an exceedingly high holding cost for the group A items.