Stratifying Customer Service Levels for Greater Profits - ABC Analysis

In my last post, I talked about the importance of safety stock, as well as its associated costs. In this post, we’ll look into how you’re setting your customer service level targets.

When you set customer service level targets, are you treating all of your items the same? Are you treating all of your customers the same? If so, does that really make sense?

One reliable approach to optimizing your inventory is to stratify your products and assign varying customer service levels to each product segment. To put it simply, you stop treating all products the same and assign higher customer service levels to your most important items.

DS BlogWhen you pause to think about it, this approach makes perfect sense. Sure, you could treat thousands or even millions of SKU items exactly the same and try to achieve, say, a 95% customer service level for each one—but that’s not a best practice. Some of those items are low-margin products sold to your once-in-a-while customers. Do you really want to clutter up your warehouse with these items?

As you decide which of your products are most important, go by measures such as units sold, dollars sold, item costs, and margins. Also factor in your customers, assigning higher importance to items purchased by your most important accounts. You can even get more sophisticated in your stratifications by considering multiple dimensions simultaneously—for example, items that are both fast moving and high margin.

What I’m describing here is often referred to as ABC analysis. It takes into account what Vilfredo Pareto first observed at the start of the 20th century and what has become known as the Pareto Principle, or sometimes, the 80/20 rule. An example of this is the fact that 20% of your products may very well account for 80% of your revenue. And it reflects the reality that if you’re out of stock when Walmart comes calling, that’s going to be much more damaging to your business than if you have to tell a mom-and-pop store that you can’t fill their order until next week.

If we can agree that not all items and not all customers are the same, then we can also agree that we should not be setting a single service level for all of your products. What you want to do is create different service level targets for each product grouping or item stratification.

The result of intelligently stratifying your products and assigning differentiated service level targets is that you can improve your overall performance with less safety stock and drive real cost out of your supply chain.

Don’t Try This with Spreadsheets, Though
Stratifying your inventory by multiple dimensions is a task that’s beyond the capabilities of any spreadsheet I’ve seen. To make inventory analysis easier, you need a system that will allow you to start quickly and increase your sophistication as you gain experience. You need to be able to define your stratification rules and generate your ABC analysis automatically. And you need to be able to update this analysis on demand. Your environment is not static, and your groupings will change.

At any rate, I’m sure you’ll agree that simply throwing more money at inventory isn’t a sustainable strategy for meeting your customer service targets. In my next post, I’ll share some strategies for calculating your ideal safety stock levels.

For more information on this topic, download our white paper, titled, "Manage What Matters: The Pareto Principle, ABC Analysis and How to Manage by Exception."


Bill Macdonald has a background that spans consulting, sales and operations. His career started as a consultant at Accenture and Deloitte Consulting. As Sales VP at global outsourcing provider HCL Technologies, he led North American sales for its financial services vertical. Prior to HCL, he served as EVP for global software solutions companies Atrion and ClearCross. He also spent six years at software giant SAP, where he was recognized as a Lifetime Top Performer.

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