ABC Inventory Control to Boost Profit and Carve Out Tax-Free Cash

The skill of a company in procuring (i.e., purchasing) parts, product and managing inventory can be the difference between success and failure. This is because:

1. The profitability of a business — or lack thereof — is established by the gross profit margin. That is, the profit left over from each sale after the direct expenses are deducted. For many businesses, the primary direct expense is procured product.
2. Inventory ties up a significant amount of cash in many businesses. Poor inventory management can drain a company’s cash, raise financial risk by requiring higher levels of borrowing, and erode profits due to outsized inventory spoilage, obsolescence or theft.

ABC inventory control is a relatively simple, widely used way to wring out cost, improve gross margins and increase inventory turns. Increased “turns,” of course, lower the amount of inventory-on-hand. If inventory-on-hand can be lowered from $500,000 to $300,000, the result is $200,000 in positive cash flow. If the business uses the accrual system of accounting for tax purposes, the windfall doesn’t trigger tax.

80-20 Rule: Focus Where You Can Have the Most Impact

The ABC inventory control method derives both its simplicity and effectiveness from the 80-20 rule. So, to begin to understand and apply ABC inventory control, the business owner should begin here: 80% of a company’s revenue is derived from 20% of its offerings. Every business owner should know which of his/her products or services produce the lion’s share of the revenue and profit.

Additionally, within this 20% you should learn what components make up 80% of the cost of these products. As Harry Figgie says in his The Cost and Profit Improvement Handbook, “These are the parts that make up the largest share of the company’s material costs.”

Armed with this basic information, the business owner can sit down his/her purchasing manager and begin looking for ways to lower cost and reduce the amounts kept on hand.

Divide and Concur

Building on the simple 80-20 rule, ABC inventory control methodology calls for each purchased item to be separated into one of three groups: A, B and C. “A” items are those relatively few that represent the highest cost and generally the greatest investment. As such, these items should be given considerable attention so:

• stock levels of these expensive items are minimized so the cash tied up in inventory is kept as low as possible, and
• stockouts of these items are rare despite the low levels maintained on hand

Conversely, items that cost the least are categorized as “C” items and can be purchased much less frequently, such as once per year. Doing so will reduce the time required to deal with ordering (and thus free up time to focus on A items) and render little financial consequence because the total dollar amount is insignificant. Of course, all other parts are labeled “B” items. These items can be ordered in smaller quantities than C parts, maybe monthly or quarterly, but much less frequently than “A” parts.

The accompanying table shows a sample breakdown of purchased items divided into categories A, B and C. The table also contains the basic data used to sort them. As you can see, four of the 30 inventory items (13%) have been designated “A” parts and account for 88.7% of total annual purchases (in dollars). Eighteen of the 30 (60%) have been designated “C” parts and account for just 1.8% of total annual purchases. The balance (8 of the 30 or 10%) are “B” parts.

Laid out this way, it is easy to see the simple logic: 89% of this sample business’ costs come from just 13% of its purchased items. Focusing on this subset will greatly simplify the purchasing and inventory management tasks. And, by focusing on the few that will yield the greatest results, the results can be significant. It entails minimizing the on-hand count of these items, frequent monitoring of stock levels for each, and frequent reordering. The high cost of these items provides the return on the extra time spent.

The C items account for a full 60% of the purchased items but consume less than 2% of the costs. It makes no sense spending much time on these items, so they should be set up to require minimal effort. Typically this means buying just once or twice a year.

The accompanying table labeled “Inventory Reduction Examples” shows how the ABC method can drastically reduce the amount of cash tied up in inventory. Here, a 62% reduction of the cash tied up in inventory.

Margin Improvement

In addition to inventory reduction and the important positive cash flow impact that a reduction can provide, ABC is a powerful tool for helping the business owner determine where to focus his/her energies to successfully wring out cost and improve gross profit margins. With the simple analysis provided, the number of inventory items that require cost reduction focus is cut by 80% or 90%.

Time, of course, is scarce for all of us. Scarce for our employees as well. This is the power of ABC inventory control methodology. By knowing where to focus, one can gain a maximum return on one’s investment of time and energy. The result can be the very survival of one’s business, or the difference between just getting by and making some real money. After all, 20% of the businesses make 80% of the profits. Apply ABC inventory control to your business and you’ll be well on your way to the top 20%.

Note: This article was adapted by David L. Perkins, Jr. using, in part, information contained in “The Cost Reduction and Profit Improvement Handbook” by Harry E. Figgie, Jr.

This article was written by the experts at The Business Owner. If you are the owner of a private business, go to www.TheBusinessOwner.com or call us at (800) 634-0605 for more no-nonsense how-to information.