In inventory management, not all items are equally profitable.

Therefore, it is important to differentiate

or classify profitable from unprofitable items. This can be done by using what is called Volume-Variance
Analysis. This method uses historical sales data to classify items based on their annual sales revenues (A,
B, C) and demand variability (X, Y, Z). This article highlights the steps involved in Volume-Variance
Analysis. We shall also discuss the benefits of using this method compared to more conventional
approaches.

The first step in product classification is the ABC Analysis. ABC Analysis is a simple scheme that divides
inventory into three classes based on annual revenue: Class A (2% or more of annual revenue); Class B
(1-2% of annual revenue); and Class C (<1% of annual revenue).

The next step in product classification is the XYZ Analysis. This method divides inventory into three
categories based on different demand patterns. Here, the Coefficient of Variation (CoV) is the variance
metric. This is calculated by dividing the standard deviation of monthly demand by the average monthly
demand of each item. Subsequently, the CoV ratios are used to classify the items into: Class X (low
variance = CV of <1.0); Class Y (medium variance = CV of 1.0-1.5); and Class Z (high variance = CV of
>1.5).

Furthermore, XYZ Analysis can be used to enhance the ABC Analysis. A combined ABC/XYZ Analysis, also
called Volume-Variance Analysis, is a system which divides the product line of a business unit into two
dimensions in order to apply various inventory management schemes to each product based on its value
in each dimension. This can be depicted as a two-by-two matrix whereby the first dimension represents
the variation of demand (CV Ratio), while the second dimension represents the volume of sales (in
percentage).

In essence, the Volume-Variance Analysis can be used to determine which items must be in stock and
when they should be ordered on a forecast basis. For instance, A and B items are statistically
forecastable, and they can also undergo a Sales and Marketing review. On another hand, CX and CY
items are forecastable, but with no Sales and Marketing review. In this context, supply chain managers
have to review inventory performance occasionally and provide recommendations. In contrast, CZ items
are not forecastable and, therefore, devoid of forecasted safety stock. Hence, cross-functional
workshops must be organized on a periodic basis to analyze and review CZ items and provide
recommendations.

The benefits of Volume-Variance Analysis are numerous. Firstly, unlike traditional methods, it helps to
reduce safety stocks in the case of ‘low-volume-high-variability' items when normal statistical
forecasting is not applicable. Secondly, it helps to reduce supply chain planning efforts by allowing staff
to concentrate more on the highly valuable A and B items which provide the greater percentage of
revenue. Also, it helps to minimize supply chain costs by using product segmentation to mitigate risk in
inventory management.

In conclusion, using only one method for product forecasting and planning is often risky, as it may apply
too much effort to the less important items. The Volume-Variance Analysis approach takes this into
consideration. It must be noted, however, that the process should be undertaken in collaboration with
other relevant departments involved in supply chain management to achieve best results.
Reference
 Milliken, A., L. (2022). Volume-Variance Analysis For Better Inventory
Management. Journal of Business Forecasting, 41(1), 9-13.