What is ABC Analysis? ABC analysis (sometimes called Pareto classification) is a simple but powerful tool for prioritizing.
The premise behind ABC analysis is that 80% of a company’s sales come from just 20% of its items.
So, by focusing on the “A” items first, companies can maximize their profits by optimizing their stock levels and improving customer service. Therefore, it is mainly used in inventory management.
This article will help you understand ABC analysis with an example, the Pareto principle, ABC classification, its importance, how to use it in inventory management, and its categories. We will also examine its pros, cons, graphical representation, and best practices.
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What is an ABC Analysis in Inventory Management?
It 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.
It can help you make better decisions about your stock and improve your overall inventory management process.
General Electric first introduced the concept of inventory management systems in 1951.
It aims to determine the level of control and frequency for each item to optimize inventory levels.
Optimization is the process of finding and correcting errors to improve productivity. For example, this can be done by finding and fixing problems with raw materials before they become more significant issues.
ABC’s method of control helps in managing inventory effectively. Efficiency by reducing cost, which in turn contributes to revenue.
A, B, and C in ABC analysis fullform is Always Better Control.
ABC Analysis Example
For example, if you’re trying to maximize profit margins, invest in high-margin items and ensure you don’t overstock lower-margin items because they take up the space needed elsewhere.
The Pareto Principle (80/20rule)
ABC analysis is based on the PARETO PRINCIPLE.
An Italian economist Vilfredo Pareto developed this law in the 1800s. He noticed that 20% of the bean plants in his garden 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 a small percentage of a group determines the vast majority of a result.
The result here may be wealth, cost, quality problems, Etc. But, on the other hand, 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. For example, concentrate 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 cases result in 80% of the effects.
When we apply this to inventory management, 20% of the items contribute to 80% of the costs.
Based on this, inventory items classify 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 / Pareto Classification
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 should get priority and more attention in the inventory.
Managing inventory involves things like,
- What items need to be ordered
- How much has to be ordered
- When to order
- How much management attention does each item need
These actions depend on the demand for the item and 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 other categories.
Importance of ABC Analysis
Inventory categorization is an integral part of inventory management. It is crucial as it helps decide how much effort and cost has to be put into different inventory items.
1) This analysis can assist with inventory control by helping businesses prioritize and manage the inventory items that are most important to their profit margins.
2) It can also help to balance inventory levels effectively, as it allows for focusing on the higher-value items rather than spreading resources too thinly across many lower-value items.
3) This, in turn, can lead to improved sales volume and potentially higher profit margins, as the valuable items are constantly available for purchase.
4) It can also reduce carrying costs by ensuring that less valuable or slow-moving items do not take up valuable storage space.
5) Additionally, it helps businesses make informed decisions about annual consumption rates and reordering of inventory items, particularly when it comes to expensive items that may significantly impact overall financial performance.
6) Finally, this analysis enables businesses to categorize and analyze their inventory items by cost and importance, which helps to decide the degree of control required for each item.
How to Perform ABC Analysis in Inventory Management?
Analysis of inventory control is a profitability analysis of an inventory item. It’s performed by calculating the total annual cost and recognizing each item’s average sale price per unit.
The process involves the following steps:
- Determine the objective – Determine and set the proper objective so that ABC analysis can be helpful in 2 ways. That decreases procurement costs and optimizes inventory levels.
- Determine the annual usage – Collecting data on annual spending on each inventory item is crucial.
- Sort the inventory items – List the Inventory Items in descending order based on yearly usage value.
- Calculate sales impact – Find out the percentage impact of each inventory item by dividing the annual item cost by the average total of all inventory items spent. The average inventory of each item is calculated by dividing the usage value by two and several orders.
- Categorized the items – Arrange these items in the stock by cumulative annual usage and cumulative percentage. Group these items as Category A, B, and C.
- Monitor the categories – Once you define the categories, then keep monitoring them to confirm your categorization is correct.
Calculation of ABC Inventory Analysis
Use the following formula to calculate ABC inventory analysis.
Annual usage = Unit cost of the item X Number of items sold annually.
It classifies inventory items into three groups. First, all inventory items are rated from A to C and grouped into groups A, B, and C.
Traditionally, these classifications are made based on dollar volume.
Category ‘A’ items are high-value inventory items with the highest annual usage value. Usually, 10-20% of the inventory items come under group ‘A.’ Therefore, their yearly usage or consumption value is about 70-80%.
Category ‘B’ items have a medium annual consumption value. Usage value is around 15-25%, typically accounting for about 30% of the inventory.
Category ‘C’ items have the lowest consumption value. That is about 5%, accounting for 50% of the total inventory.
Category ‘A’ items are known to be critical items and will get more attention and importance. Category ‘C’ items are known as trivial many.
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 depends on their importance in production.
- It helps to manage the inventory effectively by reducing the efforts.
- It also helps in financial forecasting and planning for the coming year.
- It helps assign the resources as it continuously validates the allocation of resources and ensures that class A items line up with customer demand.
- It helps to identify the profitable item so that you can provide the best customer service for that items.
- It helps to reduce the storage cost by having the exact amount of stock based on the A, B, and C classes.
- ABC classification is based on the monetary value of the items. Though consumption or economic values are negligible for some things, they could be vital for production.
- It needs periodic updates and reviews. These reviews are required since some inventory items become obsolete or get added in between.
- When a new product is added, it will not have buying history. Hence it takes work to calculate its value.
- It is not suitable for organizations with stable annual consumption values of inventory by type.
- Organizations should buy special equipment and hire more staff to perform it for more inventory items.
ABC Analysis Best Practices
Have proper classification and monitoring
Always classify the items as per the total profit margin. Keep more expensive products in class A, average expensive items in class B, and less costly items in class C.
Keep monitoring the fast-moving products. Otherwise, there will be a chance of stock-outs.
Allocation of service levels
Allocate the service levels depending on the product class. That means giving more attention to the class A items. Frequently perform cycle counting or any other inventory counting for category A items.
If you review 100 class C items in 1 hour, then review 50 class B items and 10 class A items in 1 hour.
So regular counting of class A items gives you a significant marketing impact and increases the sales performance.
Set key performance indicators for each class.
Set a clear-cut key performance indicator (KPI) for each class, along with reports and dashboards.
Evaluate the performance
Keep on analyzing the performance of each class item in the market and recategorize the items based on their cost and performance.
Keep track of inventory shipment.
Carefully monitor the shipment time and receive inventory time from one location to another.
Re-categorization of products
Depending on the market changes, demand and cost of the product change. Hence it would be best if you reclassified your inventory intermittently.
Determine the relationship between sales and inventory
As the sales increase, demand for the product also increases, so you need to increase the stock to avoid stock-outs.
It is valid for decreasing the demand for an item also. So keep on validating the item’s price and review the stock levels.
Usage of technology
Inventory managers should use an automated system to retrieve inventory easily, and the system also helps manage lead times and demand planning.
ABC Analysis Use Cases in Different Industries
ABC analysis is an inventory management technique used in various industries and organizations, such as manufacturing, retail, automotive, and warehousing. The analysis provides insight into the value of each item within an inventory or project list.
As a result, it allows managers to allocate resources efficiently by focusing on the most valuable items first. Additionally, it can help managers predict future needs and ensure that the organization’s resources are deployed optimally.
In the manufacturing industry, the business can increase profit margins by categorizing 20% of the top products. ABC analysis will be used here to determine and prioritize the materials, resources, and time required for those products.
ABC analysis helps retailers identify profitable products for their business.
ABC analysis helps the automotive industry to analyze resource utilization and equipment performance. It also helps automotive manufacturers to get real-time information on raw materials.
ABC analysis helps warehouse managers to manage higher-value inventory items and maintain safe stock to avoid stockouts.
ABC analysis first emerged in the 1900s by economist Vilfredo Pareto. He developed the famous 80/20 rule, which states that approximately 80% of outcomes come from 20% of causes.
In the 1950s, Joseph M. Juran and W. Edwards Deming brought the ABC analysis to Japan to help the economics of Japan after post-war. They are founders of the proponents of quality management.
In the 1960s, Total Quality Management (TQM) used the ABC analysis concept.
In 1974, UPC barcode and scanning came into existence, and in 1981, the Department of Defense started using Barecodes in the inventory control system. In addition, it supported ABC inventory management.
In the 1980s, lean manufacturing was introduced along with the ABC concept.
From the 1990s to the present, the ERP system has supported ABC analysis with other inventory management methods.
This method aimed to help organizations reduce costs associated with carrying too much inventory and improve their efficiency in managing stock levels.
Since then, ABC analysis has become an important part of modern management techniques and is frequently used across many industries, such as retail, manufacturing, and warehousing.
Today it is seen as an invaluable tool for businesses seeking to optimize their resources efficiently and ensure they focus on items or tasks that will bring maximum value.
How can managers use ABC Analysis to prioritize tasks and resources?
Managers can use ABC analysis to prioritize tasks and resources by focusing on the highest-priority items. Then, the analysis assigns a value to each item so managers can quickly identify the most important items.
For example, in an inventory of products, managers may decide that items with a high-value rating should be restocked first, while those with lower ratings can wait until later.
Similarly, when faced with a list of projects, managers can evaluate the urgency of each one and allocate resources accordingly. This method allows organizations to use their resources in the most efficient way possible.
ABC analysis is a technique used to organize inventory based on its importance.
It’s based on the Pareto classification, which says that 80% of your problems come from 20% of your causes. That means you should focus more time and energy on what is most important for business success.
One way to do this with inventory management is by using this analysis to understand where the company will have the most significant return on investment (ROI).
It has been known for many years in the industry. Industries, including manufacturing, hotels, and hospitals, use it and reap benefits. Still, many enterprises are yet to adopt it.
You can use this method to classify not only the inventory. It can also use with different data. In addition, many organizations apply it in other business processes like purchasing, sales, marketing, quality, and forecasting.