PRODUCTION AND OPERATIONS MANAGEMENT POMS

Vol. 19, No. 3, May–June 2010, pp. 343–352 10.3401/poms.1080.01098

DOI
ISSN 1059-1478|EISSN 1937-5956|10|1903|0343 r 2009 Production and Operations Management Society

ABC Classification: Service Levels and Inventory Costs

Ruud H. Teunter
Department of Operations, University of Groningen, PO Box 800, 9700 AV Groningen, The Netherlands, r.h.teunter@rug.nl

M. Zied Babai
BEM-Bordeaux Management School, 680 cours de la Libération, 33405 Talence Cedex, France, mohamed-zied.babai@bem.edu

Aris A. Syntetos
Centre for Operational Research, University of Salford & Applied Statistics, Manchester M5 4WT, UK, A.Syntetos@salford.ac.uk

BC inventory classifications are widely used in practice, with demand value and demand volume as the most common
A 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.
Key words: inventory management; ABC inventory classification
History: Received: May 2008; Accepted: July 2009, after 2 revisions.

1. Introduction ABC classification to set service levels, by assigning

ABC inventory classification systems are widely used
by business firms to streamline the organization and
management of inventories consisting of very large
numbers of distinct items, referred to as stock-keeping
units (SKUs). APICS (Blackstone and Cox 2008) de-
fines ABC classification as follows. ‘‘The classification
of a group of items in decreasing order of annual
dollar volume (price multiplied by projected volume)
or other criteria. This array is then split into three
classes, called A, B and C.’’ More flexible classifica-
tions with more than three classes and/or multiple
criteria have also been proposed and these will be
reviewed in section 2. We remark that, in what fol-
lows, we will use the term demand value instead of
annual dollar volume and demand volume for the sim-
pler annual demand volume criterion.
The most important reason for applying an ABC
classification is that, in most practical cases, the
number of different SKUs is too large to implement
SKU-specific inventory control methods (Ernst and
Cohen 1990). Retailers typically deal with thousands
of different SKUs (Buxey 2006) and larger (service)
organizations can have tens or hundreds of thousand
SKUs.
For inventory control, service levels constitute ar-
guably the most important performance measures. We
have encountered a number of companies that use the
343
the same service level to each SKU in a particular
class. This is in line with findings from Lee (2002)
from NONSTOP solutions (a provider of demand-
chain optimization services) and Pflitsch (2008) from
SLIMSTOCK (a provider of forecasting and inventory
management software, including ‘‘Slimstock ABC’’
for inventory classification). Both confirm from their
extensive experience of implementing inventory con-
trol software that the standard approach is to fix
service levels per class.
If a company decides to use fixed service levels per
class, then an obvious key question is what those ser-
vice levels should be. However, the literature does not
provide clear guidelines. In fact, it is not even clear
which class should get the highest/lowest service
level. On the one hand, authors have argued that A
items are the most critical for a firm in determining
the profit and should therefore have the highest ser-
vice levels in order to avoid frequent backlogs
(Armstrong 1985; Stock and Lambert 2001). On the
other hand, it has been claimed that dealing with
stockouts is not worth the effort for C items and they
should therefore get the highest service level (Knod
and Schonberger 2001). See Viswanathan and Bhatn-
agar (2005) for further discussion.
An explanation for this mixed bag of results is that
the traditional criteria of demand value and demand

344 Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society
volume for ABC classifications have not been devel-
oped from an inventory cost perspective. In this
paper, we will take such a perspective to develop an
alternative criterion based on the objective to mini-
mize total inventory cost whilst achieving a certain
required average fill rate (over all SKUs). See section 3
for details. This cost criterion ranks SKUs based on the
bD
value of hQ , where b is the criticality measured by the
shortage cost, D is the demand volume, h is the unit
holding cost, and Q is the order size.
Note that the cost criterion takes criticality of SKUs
into account through the shortage cost b. As will be
discussed in the next section, the importance of crit-
icality has been addressed by many previous authors,
especially in the context of spare parts management.
However, the two common ranking criteria do not
take it into account and neither does an alternative
criterion proposed by Zhang et al. (2001).
A comparison of the new cost criterion and the
most commonly applied demand value criterion leads
to an important insight into the ‘‘sub-optimality’’ of
the latter with respect to cost-service efficiency. Al-
though both criteria rank an SKU higher if the
demand volume is larger, the cost criterion ranks an
SKU higher if the holding cost is lower whereas the
demand value criterion does the opposite (assuming
that a higher price implies a higher holding cost, as is
common). This also explains why specialists in com-
mercial ABC applications (Pflitsch 2008) have found
that the demand volume criterion is more effective
than the most commonly used demand value criterion
in reducing inventory costs while maximizing the
service level.
Our analysis leading to the cost criterion will also
show that it is best used with a fixed cycle service
level (1–stockout probability) per class rather than
fixed fill rates per class. This has an important prac-
tical advantage, because the transformation to safety
stocks and reorder points for SKUs is much easier
from cycle service levels.
We will empirically compare the two traditional
criteria and the one proposed by Zhang et al. (2001) to
the new cost criterion, using three large real-life data-
sets, in a numerical experiment where the target av-
erage fill rate and the number of classes are varied.
The results will show that the new cost criterion sig-
nificantly and consistently outperforms all other
methods.
The remainder of the paper is organized as follows.
Section 2 shortly reviews the relevant literature on
ABC classification. In section 3, we propose the new
cost criterion based on inventory analysis. In section 4,
we compare the cost criterion to other criteria in an
extensive numerical experiment. Finally, in section 5,
we provide our conclusions, managerial insights and
directions for further research.
Teunter, Babai, and Syntetos: ABC Classification
2. Research Background
Classification of SKUs is widely adopted by organi-
zations. The main purpose of classification is to
simplify the task of inventory management, by set-
ting stock control methods and service levels per class
rather than for each SKU separately. We remark that
forecasting procedures can also be class-dependent
(Boylan et al. 2008; Syntetos et al. 2005). However, our
focus in this paper is restricted to inventory control
and service levels.
In some environments, especially in the service/
maintenance industries, the rank of an SKU is deter-
mined by its criticality for the functioning of a piece of
equipment (Naylor 1996). In most practical situations,
however, classification is based on SKU-specific crite-
ria such as the demand value (price multiplied by
demand volume) and the demand volume for an
SKU.
Obviously, ABC classification was originally named
and designed for three classes: A, B, and C. However,
the method can easily be extended to more classes,
simply by dividing the ranked SKUs into more
groups. The number of classes is usually limited to
at most six (Graham 1987; Silver et al. 1998).
As discussed in section 1, the traditional classifica-
tion approach is based on a single criterion. Demand
value is the most commonly applied one, followed by
demand volume. Another single criterion, discussed
in detail later in this section, was proposed by Zhang
et al. (2001). Our analysis will also lead to the proposal
of a single criterion upon which the classification of
SKUs may be based. Obviously, a major advantage of
using a single criterion is the simplicity.
However, a number of authors (Buzacott 1999; Chen
et al. 2008; Ernst and Cohen 1990; Flores and Whybark
1987; Ng 2007; Partovi and Burton 1992; Ramanathan
2006; Zhou and Fan 2007) have considered the use of
multiple criteria, such as the certainty of supply, the
rate of obsolescence, the lead time, costs of review and
replenishment, design and manufacturing process tech-
nology, and substitutability. Accordingly, multi-criteria
classifications have been developed. Various multi-
criteria methodologies have been considered, including
weighted linear programming, analytic hierarchy pro-
cess (AHP), and operations-related groups (ORG). An
alternative for using multi-criteria methodologies is to
use multiple way classifications, e.g., a two-way clas-
sification by purchase cost and demand volume.
Our inventory cost analysis will show that, for
achieving cost optimal (or cost-service efficient) solu-
tions, a single criterion is sufficient. However, that
criterion does take four system parameters into ac-
count: demand volume, holding cost (purchase price),
shortage cost (criticality), and average order quantity.
Alternatively, a four-way classification could be used
Teunter, Babai, and Syntetos: ABC Classification
Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society
but this would not produce gains in terms of inven-
tory cost and would be more difficult to implement.
With one exception, to the best of our knowledge,
ABC classification methods have not been proposed
or analyzed from an inventory cost perspective. This
exception is a study by Zhang et al. (2001), who do
propose a classification criterion (given in section 3,
after notations are introduced) based on inventory
theory. The derivation of this criterion is based on the
assumption that service is measured by the probabil-
ity that an order arrives on time, also known as the
cycle service level.
In this paper, we will instead measure service as the
fill rate, i.e., the fraction of demands that are satisfied
directly from stock on hand. This is the most common
way of measuring service (see, e.g., Axsäter 2006; Sil-
ver et al. 1998), and is also used by Zhang et al. (2001)
to evaluate their criterion (and other proposed inven-
tory control heuristics). The main advantage of using
the fill rate is that it directly reflects the service as
experienced by the customers. We will derive a new
criterion based on the fill rate objective, and contrast it
to the criterion of Zhang et al. (2001) and the tradi-
tional demand volume and demand value criteria.
3. A New ABC Classification Criterion
In practice, inventory managers usually try to mini-
mize cost while maximizing the service level. The
most common way (see, e.g., Silver et al. 1998) to
define the service level is as the fraction of demand
that is satisfied directly from stock on hand; the so-
called fill rate. For a multi-SKU inventory system,
the average fill rate over all SKUs can be calculated
(see, e.g., Thonemann et al. 2002) as the weighted
average of the single-SKU fill rates, where the weights
are the fractions of demands for the different SKUs.
Such a system with a mixed cost-service objective is
difficult to analyze in general. For this reason, inven-
tory theory is dominated by a cost approach rather
than a service approach. In a cost approach, instead of
including a service restriction, missed demands in-
cur a penalty cost and the objective is to minimize
the total cost including inventory and penalty costs.
The practical validity of this alternative cost approach
lies in the fact that it leads to the same set of cost-
service efficient solutions as the corresponding service
approach (see, e.g., Silver et al. 1998). In this section,
we will use a cost approach to derive a new criterion
for ranking SKUs.
So, we consider a multi-SKU inventory system where
the objective is to minimize the total cost, consisting of
inventory holding costs (per SKU and per time unit)
and penalty/shortage costs per backordered demand.
We do not assume a specific reorder policy, but will
show that our analysis and the resulting criterion apply
345
to both reorder point, reorder quantity (R, Q) policies
as well as reorder point, order-up-to-level (s, S) policies,
and for both continuous and periodic review. These
are the most commonly used inventory policies. The
criterion can also be used for any type of demand
distribution, although we will consider only Normal
and Gamma distributed demand in our numerical
investigation.
We introduce the following notation. Note that
‘‘(average)’’ is added for the order quantity as it may
vary for an (s, S) inventory policy.
N: number of SKUs
bi: penalty cost (per backordered item) for SKU i
CSLi: cycle service level for SKU i
Di: demand per unit time for SKU i
FRi: fill rate for SKU i
hi: inventory holding cost (per item per time unit)
for SKU i
Li: lead time for SKU i
Qi: (average) order quantity for SKU i
SSi: safety stock (average inventory level just
before an order arrives) for SKU i.
The total cost for all SKUs can be expressed as
XN  
Qi
hi SSi þ hi þ bi Di ð1  FRi Þ :
2
ð1Þ
i¼1
Here, the three terms represent the safety stock cost,
the cycle stock cost and the shortage cost, respectively.
As is shown in Appendix A, minimizing the total cost
leads to the following approximate newsboy-type op-
timality condition for each SKU:
hi Q i
CSLi ¼ 1  : ð2Þ
bi D i
Note from (2) that the approximately optimal cycle
service level can be negative (because of the underlying
approximation) for ‘‘extreme’’ cases with very low de-
mand as well as backorder costs. However, this does
not affect the general applicability of the ABC method
that we will develop, as we will only use (2) to rank the
SKUs and not to actually set their service levels.
We remark that for normally distributed demand
and a continuous review (R, Q) policy, the safety stock
corresponding to (2) can be calculated pffiffiffiusing the well-
known ‘‘safety factor’’ rule as ki si L where safety
factor ki can be calculated using the inverse distribu-
tion function for standard normal demand (available
in Excel) at CSLi.
Condition (2) has the following intuitive cost-
balance explanation. Holding an SKU of type i in
safety stock for the length Q
Di of a replenishment cycle
i
leads to a holding cost of hDi Qi i per unit of SKU. How-
ever, if a cycle ends with a stock-out then each unit
 Teunter, Babai, and Syntetos: ABC Classification
346 Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society

of safety stock prevents a backorder at cost bi,
and hence the expected backorder cost reduction is
bi(1  CSLi). So, (2) balances holding and backorder
costs optimally.
Condition (2) implies that the cycle service level for
an SKU is increasing in the ratio hbii D Qi . Based on this
i
result, we propose the following new ABC classification
method: rank the SKUs based on the ratio hbii D
Qi in descending
i
order and fix the cycle service level per class. In other
words, an SKU with higher optimal CSL (or higher
bi Di
hi Qi Þ gets a higher rank. Because this new ranking
criterion and classification are based on a cost min-
imization approach, we refer to them as cost criterion
and cost classification.
An advantage of the cost criterion, compared with
the common criteria and to the alternative proposed
by Zhang et al. (2001), is that it takes shortage cost
(or criticality) into account. This implies that it can
also be used in situations, such as for spare parts
management, where criticality is essential.
In common with the demand value and demand
volume classifications, the cost method also ranks
SKUs higher if the demand rate is larger. In addition,
higher holding cost or order quantities induce a de-
crease in the values of the ratio, which is an intuitively
appealing property from an inventory cost point
of view. Note that as a higher holding cost typically
indicates a higher purchase price, this holding cost
effect is opposite to the price effect of the demand
value classification. Due to this ‘‘reverse’’ use of
prices, we expect the demand value classification to
perform worse than the demand volume classification
(that ignores prices) and much worse than the cost
classification. The results from an empirical investi-
gation in section 4 will confirm this.
The criterion of Zhang et al. (2001) is hD2 Li . As our cost
i i
criterion, this one ranks an SKU higher if the demand
rate is larger or if the holding cost is smaller. However,
the holding cost is squared and hence its effect more
dominant. Furthermore, the order quantity has no
effect on rank, but the lead time does. So, aside from
the inclusion of criticality, there are other major differ-
ences between our criterion and that of Zhang et al.
(2001). Section 4 will show that our criterion performs
significantly better than that of Zhang et al. (2001),
and that both outperform the traditional criteria.
It is interesting to note that, despite the fill rate ob-
jective that was translated into a penalty cost per
backorder, the optimality condition (2) fixes the cycle
service level rather than the fill rate of an SKU. Fixing
stockout probabilities per class instead of fill rates has
the important advantage of easier implementation.
Transforming a fill rate into a reorder point involves
the use of complicated inverse loss functions (see, e.g.,
Axsäter 2006), whereas the inverse distribution func-
tion is sufficient for linking the stockout probability to
the reorder point. Indeed, inventory planning tools
sometimes do not allow the use of fixed fill rates. SAP
R/3, for instance, is restricted to the use of stockout
probabilities, although the more advanced planning
and optimization tool SAP APO does offer the option
to fix fill rates as well.
4. Empirical Investigation
4.1. Empirical Data
The empirical investigation is based on three real life
datasets. Dataset 1 is from a warehouse supplying
spare parts globally for the installed base of machines
that are used in the textile industry. Dataset 2 is from a
retailer that sells bike and car parts and accessories.
Dataset 3 is from a retailer that sells do-it-yourself
products. Table 1 shows the size of these datasets at
well as key statistics for demand, lead time, and pur-
chase price.
To apply and evaluate the different classification
schemes, we also need information on the order
quantities, demand variations, and holding costs. All
datasets contain information on the order quantity.
Datasets 1 and 2 also contain a 24-months demand
history for each SKU that was used to calculate the

Table 1 Descriptive Statistics for the Three Datasets

Dataset 1 (4,799 SKUs) Dataset 2 (39,274 SKUs) Dataset 3 (9,086 SKUs)

Demand Lead-time Price Demand Lead-time Price Demand Lead-time Price

(weeks) (weeks) (euro) (weeks) (weeks) (euro) (weeks) (weeks) (euro)
Minimum 0.01 0.5 0.01 0.01 0.3 0.01 0.04 2 0.01
25%ile 0.3 4 0.6 0.04 0.3 1.7 1.7 2 0.9
Median 1.3 4 5 0.1 0.3 5 7 2 7
75%ile 6 7 28 0.3 0.3 15 24 2 21
Maximum 4,142 33 3,021 35 0.3 1,528 41 Mil. 17 339

Note that the lead time is constant and small across all SKUs for Dataset 2, which is because all orders are delivered from a large warehouse within the same country in
two days.
Teunter, Babai, and Syntetos: ABC Classification
Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society
standard deviation of demand per month, which was
then converted to the standard deviation of lead time
demand. No demand histories are available for
dataset 3, but we were able to estimate standard de-
viations based on the current reorder points (that are
given) by assuming that a safety factor of two was
used for all SKUs.
There is no information on the (annual) holding cost
rate and therefore it is not possible to multiply pur-
chase prices by that rate to obtain holding costs.
However, this is not a problem since the holding cost
rate is only a scaling factor and therefore any value
will lead to exactly the same relative cost results
(per cent cost increase of one method compared with
another). Therefore, and also because relative cost re-
sults are easier to interpret and compare across
datasets, we will present relative instead of absolute
cost figures in what follows.
4.2. Experimental Setting
All three companies from which the datasets were
obtained apply a continuous review (R, Q) inventory
policy, which we also do in our numerical investi-
gation. As is common in the literature (for safety
stock calculations), order quantities (Q) are assumed
to be fixed as they often result from constraints on,
e.g., minimal order or packet size. However, by using
different classes and corresponding optimal class ser-
vice levels (of which the calculation is discussed later),
the various ABC criteria lead to different order levels
(R). That is, they distribute the safety stock in different
ways over all SKUs. Because firms typically do not
plan for orders to come in late, we restrict the focus
on positive safety stocks by not allowing the cycle
service level (i.e., the probability that an order arrives
on time) of any class to be less than 50%.
We use the Normal distribution as well as the
Gamma distribution to model lead time demand.
The Normal distribution is the most widely applied
distribution for inventory control. However, it may
not be suitable for SKUs with slow moving demand,
since such SKUs typically have large coefficients of
variation, resulting in a considerable probability that
demand is negative when using the Normal distribu-
tion (with the correct mean and variance). Therefore,
we also consider the nonnegative and skewed Gamma
distribution, which has been suggested by many oth-
ers (e.g., Aviv and Federgruen 2001; Bagchi et al. 1986;
Das 1976) as a suitable alternative to the Normal dis-
tribution for modelling lead time demand.
We compare four different ranking criteria: demand
value, demand volume, Zhang et al., and cost. Each
criterion is applied with three and six classes. With three
classes, the sizes are determined using the commonly
applied rule that classes A, B, and C contains about 20%,
30%, and 50% of all SKUs (see, e.g., Jacobs et al. 2009;
347
Slack et al. 2007; Stevenson 2007—the recommended
percentages do vary somewhat). As this implies that
class sizes increase with a reasonably constant factor, we
applied this logic (and round to integer numbers) to
obtain class sizes of 4% (A), 7% (B), 10% (C), 16% (D),
25% (E), and 38% (F) when there are six classes. We
remark that we also experimented with different (meth-
ods for setting) class sizes, but that did not lead to
(consistently) better results or different results on the
comparative performance of the four criteria.
For each criterion and number of classes, we (use
the Solver tool in Excel to) find the cycle service levels
per class that minimize the total inventory cost for all
SKUs, whilst ensuring a certain overall (i.e., over all
SKUs) target fill rate. Conversion of cycle service
levels to order levels (R) is straightforward by using
the inverse distribution function. Calculation of the fill
rate for an SKU at a given service level can be done
using the results of Appendices A and B (for Normal
and Gamma demand). The overall fill rate is the
average over all SKUs weighted by their annual
demand rates. The specific target fill rates that we
consider are 95% and 99%.
Besides calculating the minimum cost solution for
each of the criteria and either three or six classes, we
also calculated the optimal solution without a restric-
tion on the number of classes. Although this solution
is obviously not implementable in an ABC framework,
it does provide a useful lower bound on the cost that
can be used as a benchmark. For ease of presentation,
we will refer to this solution as the optimal solution in
section 4.3.
4.3. Results
Since order quantities are constant and not influenced
by the classification criterion, cycle inventory costs are
the same for each criterion. Therefore, we will present
figures for the relative safety stock cost only.
It turns out that the results for Normal and Gamma
demand are very similar. Therefore, we first discuss
the results for Normal demand extensively, followed
by a shorter discussion on Gamma demand.
Tables 2–4 summarize the relative cost performance,
measured by the percentage increase in the safety
stock cost compared with the optimal solution (with-
out a restriction on the number of classes), for Normal
demand. Detailed results with optimal cycle service
levels and corresponding fill rates for all classes are
provided in Appendix C for Dataset 1. Similar results
were obtained for the other two datasets. Note that for
Dataset 2 (Table 3) only the results for a 99% target fill
rate are presented. The reason for this is that due to
the small lead time of 2 days for all SKUs (see also
section 4.1), a 95% (or in fact even a 97%) fill rate is
achieved with zero safety stock (i.e., a cycle service
level of 50%) for all SKUs.
 Teunter, Babai, and Syntetos: ABC Classification
348 Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society

Table 2 Summarized Results for Dataset 1 and Normal Demand Table 4 Summarized Results for Dataset 3 and Normal Demand

Safety stock cost (% increase over optimal) Safety stock cost (% increase over optimal)

Target No. of Demand Demand Zhang et al. Cost Target No. of Demand Demand Zhang et al. Cost
fill rate classes value volume criterion criterion fill rate classes value volume criterion criterion
95% 3 2041 1096 72 38 95% 3 753 362 99 63
6 1661 477 20 20 6 740 278 39 14
99% 3 363 196 43 22 99% 3 157 74 30 23
6 336 174 22 8 6 154 58 18 5

Although the exact figures vary per dataset, the
qualitative results are the same. Firstly, the new cost
criterion is the clear winner. The criterion from Zhang
et al. (2001) also performs much better than the two
traditional criteria. Indeed, the performance of the tra-
ditional criteria can be described as dramatic, with
the worst performance for the most commonly used
demand value criterion. Please recall from section 3
that we expected the demand value criterion to have
the poorest performance, as it ranks more expensive
SKUs higher whereas, from a cost perspective, they
should be ranked lower.
Another result for the cost criterion is that there is a
considerable cost reduction that results from using six
instead of three classes. Doing so reduces the relative
safety stock cost (compared with the optimal solution)
from 31% to 10%. The small latter figure also indicates
that six classes are sufficient to obtain a nearly optimal
solution.
Recall from section 1 that there is no agreement in
the literature on which class should get the highest
this, we present the summarized results for Dataset 1
in Table 5.
The cost criterion performs best for Gamma
demand as well, and six classes are sufficient for ob-
taining a solution that is very close to optimal. All
other findings for Normal demand apply to Gamma
demand as well.
5. Conclusion and Extensions
In this paper, we have studied ABC classifications
where, as is the standard approach in practice, service
levels are fixed per class. Based on well-known results
from the inventory theory, we proposed a new cost
criterion for ranking SKUs: based on hbii D Qi , where bi is
i
the shortage cost (i.e., the criticality), Di is the demand
rate, hi is the inventory holding cost, and Qi is the
order quantity for SKU i.
The cost criterion can be applied using the follow-
ing simple steps.
1. Rank all SKUs in descending order of hbii D Qi .
i

service level when the two traditional ranking criteria
are used. The detailed results in Appendix C and
similar results for the other two datasets offer an
explanation for this lack of agreement, since neither
the demand volume nor the demand value criterion
have a consistent positive or negative ‘‘trend’’ in
the cycle service levels or fill rates over the classes.
The new cost criterion ‘‘by design’’ does show the
cycle service level to be highest for class A, then B,
and so on. Note, however, that this does not neces-
sarily imply the same pattern for the fill rates, as those
depend on order quantities as well.
As mentioned at the start of this section, the results
for Gamma demand are very similar. To illustrate
2. Divide the SKUs into classes A, B, and so on. Our
results showed that using increasing class sizes
of 20%, 30% and 50% for three classes (as is
usual) and 4%, 7%, 10%, 16%, 25% and 38% for
six classes works well.
3. Fix the cycle service level for each class, where A
should have the highest service level, followed
by B, and so on.
An important advantage of the cost criterion over
those discussed in the literature is that criticality is
taken into account. Moreover, since criticality is com-
Table 5 Summarized Results for Dataset 1 and Gamma Demand

Safety stock cost (% increase over optimal)

Table 3 Summarized Results for Dataset 2 and Normal Demand
Target No. of Demand Demand Zhang et al. Cost
Safety stock cost (% increase over optimal) fill rate classes value volume criterion criterion
Target No. of Demand Demand Zhang et al. Cost 95% 3 1634 916 72 45
fill rate classes value volume criterion criterion 6 1383 443 19 6
99% 3 410 138 8 7 99% 3 361 183 28 16
6 401 115 5 4 6 340 138 10 5
Teunter, Babai, and Syntetos: ABC Classification
Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society 349

bined with other relevant parameters into a single We introduce the following notation
criterion, more complex multi-criteria methods can
D: Demand (per time unit)
be avoided.
L: Lead time (in time units)
In an extensive numerical experiment using three
m: Expected lead time demand
real life datasets, we compared the cost criterion with
f(.): Probability density function of lead time
the traditional demand value and demand volume cri-
demand
teria and to another criterion proposed by Zhang et al.
F(.): Probability distribution function of lead time
(2001). As these other methods do not take criticality
demand
into account, this was not considered in the experiment.
The cost criterion consistently outperformed all other
We further define the loss function G(.) as
methods across datasets, target service levels (95% and
99%), and types of demand distribution (Normal and Z 1
Gamma) in minimizing the safety stock cost. Zhang GðxÞ ¼ ðv  xÞfðvÞdv:
et al.’s criterion also performed reasonably well, and x

certainly much better than the two traditional criteria. With this definition, we can express (see section 5.10
Both the demand value and the demand volume cri- of Axsäter 2006) the fill rate as
teria more than doubled the safety stock cost in all cases
considered, with the most common demand value cri- GðRÞ  GðR þ QÞ
FR ¼ 1 
terion providing the worst performance. Q
Based on these results, we recommend the use of
the cost criterion in combination with fixed cycle ser-
vice levels for each class. One should keep in mind and the safety stock as
that our focus was purely on minimizing inventory Z RþQ 
costs whilst maximizing service. If classification is 1
Rmþ GðuÞdu :
also used for other reasons, e.g., to determine the Q R
types of inventory policies used, the frequency of Using these expressions, the average cost per time
stock counts or the frequency of orders to be placed, unit (1) can be rewritten as
then other performance measures may come into play.
Nevertheless, we feel that the size of the potential Z RþQ 
1
savings warrants consideration of the newly proposed C ¼ hðR  m þ Q=2Þ þ h GðuÞdu
Q R
classification method in these situations as well. This ðA1Þ
leads to an interesting direction for further research, D
namely to evaluate the cost classification method in þ b ½GðRÞ  GðR þ QÞ:
Q
such settings.
Another avenue for future research is to develop To avoid confusion of (A1) with cost expression
and test rules of thumb for how to set the cycle service (5.69) in section 5.10 of Axsäter (2006), we remark
levels for the various classes when applying the cost that we use notation m instead of m 0 for the expected
criterion. Simple rules may be preferred in practice lead time demand, and that our loss function G(.)
over finding the optimal cycle service levels as was can apply to any distribution and not just stand-
done (in Excel) for our numerical experiment. Based ard normal demand. The latter also explains the
on (2), a logical rule is to set the stockout probability standard deviation terms in expression (5.69) of Axsäter
(1–cycle service level) for each class proportional to (2006).
the reciprocal of the average value of the criterion for It is common in the literature (see section 5.10 of
that class. However, extensive testing is needed. Axsäter 2006) to replace the exact cost by a simpler
approximate cost expression. If there are relatively
Appendix A. Inventory Cost Analysis few backorders (as is typical in practice where target
In this Appendix, we will derive (2) as the approxi- service levels are usually at least 95%) and if Q is
mate optimality condition for the reorder level. We relatively large (as is again typical to avoid extensive
start by doing so for the continuous review (R, Q) ordering costs and because of minimum required
policy, and then consider the continuous review (s, S) order quantities), then the following expression is an
policy and finally the periodic review (s, S) policy. accurate approximation of (A1):

Continuous Review (R, Q) Policy ~ ¼ hðR  mÞ þ h Q þ b D GðRÞ:

The continuous review (R, Q) policy triggers an order
of size Q when the inventory level drops to R, as-
suming continuous demand.
C ðA2Þ
2 Q
Note that this cost approximation is easy to
interpret. The first part of (A2) is the approximate
 Teunter, Babai, and Syntetos: ABC Classification
350 Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society

safety stock cost. The second part represents the Appendix B. Calculating the Loss
average cycle holding cost from ordering Q items at a Function for Normal and Gamma
time. The average number of orders placed per time
unit (year) is D/Q and the expected backorder when
Demand Distributions
an order arrives is approximately G(R), leading to the As in Appendix A, we define the loss function G(.) as
third part. Z 1
~ is convex in R and hence
It is easy to verify that C GðxÞ ¼ ðv  xÞfðvÞdv:
x
the optimum reorder point is obtained by setting the
derivative to zero, which gives In this appendix we derive expressions for G(x) that
are used in our numerical experiment, starting with
D normally distributed demand and followed by
hþb ðFðRÞ  1Þ ¼ 0 gamma distributed demand.
Q
Normal Demand
or equivalently (see also section 5.10 of Axsäter 2006 Let us denote the Normal probability density and
for normally distributed demand) distribution functions by j(.) and F(.), respectively. As
shown in section 5.3.4 of Axsäter (2006), the loss
hQ function for a normal distribution with mean m and s
FðRÞ ¼ 1  :
bD can be rewritten as
      
Rm Rm Rm
Since F(R) is equal to the cycle service level, this GðRÞ ¼ s j  1F :
s s s
condition is equivalent to (2).
This can easily be calculated in Excel.
Continuous Review (s, S) Gamma Demand
The (s, S) policy triggers an order whenever the Let us denote the Gamma probability density and
inventory position drops to or below s, replenishing distribution functions with parameters b and c by
the inventory position to S. Since the (s, S) policy is fc, b(x) and Fc, b(x), respectively. The probability density
equivalent to an (R, Q) policy with R 5 s and Q 5 S  s function is given by
for continuous demand, we only need to consider
discrete demand here. xc1 exb
fc;b ðxÞ ¼ :
In fact, the key difference between discrete b bGðcÞ
and continuous demand is that the inventory position
can ‘‘undershoot’’ the reorder level. If this under- So
shoot is included in the lead time demand, then the Z þ1
above analysis for (R, Q) policies still holds. This GðRÞ ¼ ðx  RÞfc;b ðxÞdx
can be done by adding the expected undershoot to m, R
Z þ1 Z þ1
and by redefining f(.) and F(.) so that they correspond ¼ xfc;b dx  R fc;b ðxÞdx
to the distribution of lead time demand plus under- R
Z 1 R
shoot.

¼ xfc;b dx  R 1  Fc;b ðRÞ

R

Periodic Review (s, S) Since

The periodic review policy only reviews stock at the Z 1 Z
Gðc þ 1Þ 1 xc eb
x
beginning of each review period (of T time units).
xfc;b dx ¼ b dx
Therefore, as for the continuous review (s, S) policy
under discrete demand, the inventory position may
drop below the reorder point s. This undershoot can
be incorporated in the same way as discussed for the
continuous review (s, S) policy.
We note that, in the literature (see, e.g., Axsäter 2006),
it is often assumed that all demand in a review period
takes place directly after the replenishment decis-
ion. Under this assumption, the relevant undershoot
distribution corresponds to demand over the ‘‘full’’ T
time units, so that the distribution for lead time demand
plus undershoot is that over L1T time units.
R  GðcÞ R b bGðc þ 1Þ
¼ bc 1  Fcþ1;b ðRÞ ;
we get
GðRÞ ¼ bc  R þ RFc;b ðRÞ  bcFcþ1;b ðRÞ:
As for normal demand, it should be straightforward
to apply this expression in Excel as the Gamma
distribution function is available. However, we dis-
covered bugs in this specific Excel function (for small
means and large variances) and had to resort to FOR-
TRAN for these calculations.
Teunter, Babai, and Syntetos: ABC Classification
Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society 351

Appendix C. Detailed Results for Dataset 1 and Normal Demand

Table C1 Detailed Results for 3 Classes and a 95% Target Average Fill Rate

Demand value Demand volume Zhang et al. criterion Cost criterion

Class 1–Stockout Pr. FR 1–Stockout Pr. FR 1–Stockout Pr. FR 1–Stockout Pr. FR

A 0.6493 0.8922 0.7936 0.9564 0.8864 0.9804 0.8953 0.9820
B 0.9159 0.9857 0.5000 0.8798 0.5000 0.8354 0.5000 0.8424
C 0.9442 0.9954 0.5000 0.8788 0.5000 0.8284 0.5000 0.8370

Table C2 Detailed Results for 6 Classes and a 95% Target Average Fill Rate

Demand value Demand volume Zhang et al. criterion Cost criterion

Class 1–Stockout Pr. FR 1–Stockout Pr. FR 1–Stockout Pr. FR 1–Stockout Pr. FR

A 0.5000 0.8164 0.9232 0.9863 0.9783 0.9972 0.9974 0.9997
B 0.7377 0.9251 0.5000 0.8704 0.9152 0.9854 0.9543 0.9930
C 0.7644 0.9406 0.5000 0.8773 0.6466 0.9165 0.5691 0.8868
D 0.8814 0.9773 0.5000 0.8801 0.5000 0.8369 0.5000 0.8449
E 0.9162 0.9884 0.5000 0.8783 0.5000 0.8291 0.5000 0.8339
F 0.9523 0.9966 0.5000 0.8870 0.5000 0.8300 0.5000 0.8402

Table C3 Detailed Results for 3 Classes and a 99% Target Average Fill Rate

Demand value Demand volume Zhang et al. criterion Cost criterion

Class 1–Stockout Pr. FR 1–Stockout Pr. FR 1–Stockout Pr. FR 1–Stockout Pr. FR

A 0.9015 0.9788 0.9748 0.9964 0.9865 0.9983 0.9902 0.9988
B 0.9689 0.9955 0.6658 0.9335 0.9668 0.9946 0.9689 0.9952
C 0.9913 0.9994 0.5000 0.8788 0.5000 0.8284 0.5000 0.8370

Table C4 Detailed Results for 6 Classes and a 99% Target Average Fill Rate

Demand value Demand volume Zhang et al. criterion Cost criterion

Class 1–Stockout Pr. FR 1–Stockout Pr. FR 1–Stockout Pr. FR 1–Stockout Pr. FR

A 0.8101 0.9519 0.9990 0.9999 0.9990 0.9999 0.9990 0.9999
B 0.9395 0.9877 0.9305 0.9900 0.9990 0.9999 0.9942 0.9993
C 0.9481 0.9906 0.7995 0.9655 0.9727 0.9963 0.9818 0.9977
D 0.9712 0.9957 0.6992 0.9426 0.8963 0.9798 0.9536 0.9925
E 0.9804 0.9978 0.6072 0.9153 0.8025 0.9530 0.7377 0.9338
F 0.9883 0.9993 0.5000 0.8870 0.5000 0.8300 0.5000 0.8402

352 Production and Operations Management 19(3), pp. 343–352, r 2009 Production and Operations Management Society
Acknowledgments
The authors wish to thank the Department Editor and the
anonymous reviewers, whose comments have greatly im-
proved the content of this paper. The research described in
this paper has been supported by the Engineering and
Physical Sciences Research Council (EPSRC, UK) grant
no. EP/D062942/1. More information on this project may
be obtained at http://www.mams.salford.ac.uk/CORAS/
Projects/Forecasting/
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