ABC Classification: Service Levels and Inventory Costs

ABC inventory classifications are widely used in practice, with demand value and demand volume as the most common ranking criteria. The standard approach in ABC applications is to set the same service level for all stock keeping units (SKUs) in a class. In this paper, we show (for three large real life datasets) that the application of both demand value and demand volume as ABC ranking criteria, with fixed service levels per class, leads to solutions that are far from cost optimal. An alternative criterion proposed by Zhang et al. performs much better, but is still considerably outperformed by a new criterion proposed in this paper. The new criterion is also more general in that it can take criticality of SKUs into account. Managerial insights are obtained into what class should have the highest/lowest service level, a topic that has been disputed in the literature.