This post outlines everything that you need to know about ABC Analysis and the Pareto principle.
It will also let you know how to do the ABC classification and analysis in inventory management.
What is ABC analysis?
Definition of ABC analysis: ABC Analysis is an inventory categorization technique. In this technique, all inventory items are grouped into different categories. These categories are based on the value and quantity of the items.
ABC analysis concept for inventory systems was first introduced by General electric in 1951.
Many organizations carry a large volume of inventory. Inventory includes raw materials, supplies, finished goods, and machine parts.
Proper management and optimization of these items is a very crucial function. Crucial as they are essential assets of the company and contribute to the production cost.
Improper management of inventory can affect the entire supply chain.
The main aim of ABC analysis is to determine the level of control and frequency of review of all items.
ABC’s method of control helps in managing inventory effectively. Efficiency by reducing cost, which in turn contributes to the revenue.
ABC analysis abbreviation: ABC in ABC analysis stands for Always Better Control.
Pareto Principle (80/20)
ABC Analysis is based upon PARETO PRINCIPLE.
The law was developed by an Italian economist Vilfredo Pareto in the 1800s. The story is, in his garden, he noticed that 20% of the bean plants generated 80% of the excellent bean pods. This observation caused him to think about unequal allocation patterns everywhere.
80% of the results will come from just 20% of the action.
It is based on the principle that the vast majority of a result is determined by a small percentage of a group.
The result here may be wealth, cost, quality problems, etc. The group may be the number of people, items, etc.
It is often stated as the 80/20 rule.
It is used in inventory counting and quality systems. To concentrate attention on the small 20% number of sources that account for 80% of inventory value or quality issues.
In other words, according to the Pareto principle, 20% of causes result in 80% of the effects.
When we apply this to inventory management, we can say that 20% of the items contribute to 80% of the costs.
Based on this, inventory items are classified into three categories.
It is a synonym for ABC analysis. This analysis classifies items into different categories depending on their annual usage.
It is a power-law probability distribution. In a large number of real-world situations, we can find it. It is based on the Pareto principle.
ABC Classification is an inventory control technique that classifies inventory items into three categories based on their priorities.
- A- Extremely important
- B-Moderately important
- C-Relatively important
It allows management to decide which items in the inventory should get priority and more attention.
Managing inventory involves things like,
- What items need to be ordered.
- How much has to be ordered.
- When to order.
- How much management attention each item needs.
These actions depend on the demand for the item as well as the lead time. Taking these actions every time, for each inventory item will lead to inefficiency. That as well as increases cost.
ABC method cuts down the cost involved in checking all inventory items. That is achieved by applying different levels of control for different categories.
What is the importance of ABC analysis?
ABC analysis is one of many inventory categorization techniques.
Inventory categorization is an integral part of inventory management. It is important as it helps in deciding how much effort and cost has to be put for different inventory items.
ABC Analysis is useful in deciding the degree of control required for each inventory item.
In the ABC analysis method, ‘A’ category items are the most valuable items and are less in quantity. Since the value of these items is more, management has to put tight control over these items.
Similarly, C category items have less value and are more in quantity. Since the value is less, management need not spend much effort in controlling these items.
This way, the application of ABC analysis helps in identifying and controlling items that have a significant impact on total inventory cost.
How is inventory analysis done?
The process of ABC analysis involves the following steps:
- Determining the annual usage for each inventory item for one year
- Inventory Items are listed in descending order based on annual usage value
- Percentage of total usage value for each item is calculated
- The average inventory of each item is calculated by dividing the usage value with two and a number of orders.
- Arrange these items in the inventory by cumulative annual usage and cumulative percentage.
- Group these items as Category A, B, and C.
i.e., Annual Usage = Unit cost of the item * Annual usage quantity.
Categories of ABC analysis
It classifies inventory items into three groups. All inventory items are rated from A to C. They are grouped as group A, group B, and Group C.
Traditionally, these classifications are made based on dollar volume.
Group ‘A’ items are those whose annual usage value is highest. Usually, 10-20% of the inventory items come under group ‘A’. Their annual usage or consumption value is about 70-80%.
Category ‘B’ items have a medium annual consumption value. Usage value is around 15-25%, and they typically account for about 30% of the inventory.
Category ‘C’ items have the lowest consumption value. That is about 5%, and they account for 50% of the total inventory.
Category ‘A’ items are known to be critical few items. Category C items are known as trivial many.
More importance and attention will be given to group A items.
Advantages of ABC analysis
It is easier for inventory managers to use since the items are already in the inventory. Efforts are only to segregate them based on some calculations of the available data.
Many ERP systems will have built-in processes to undertake it.
- It allows managers to exercise selective control over the items. Control depending on their importance in production.
- It helps to manage the inventory effectively by reducing the efforts and cost.
- It also helps in financial forecasting and planning for the coming year.
Disadvantages of ABC analysis
- ABC classification is based on the monetary value of the items. Though consumption value or monetary values are negligible for some items, they could be vital for production.
- It needs periodic updates and reviews. These reviews needed since some inventory items become obsolete or get added in-between.
Graphical representation of ABC analysis
ABC analysis is known for many years in the industry. Industries, including manufacturing, hotels, and hospitals, are using it and reaping benefits. Still, many industries are yet to adopt it.
This method can be used to classify not just the inventory. It can be used with different data. Many organizations are applying it in other business processes like purchasing, sales, marketing, quality, and forecasting.
Yet, its significance is mainly known in inventory management and in sales&distribution.