What is ABC Analysis? (Always Better Control Analysis)

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Abc Analysis definition

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.

What is an ABC analysis?

ABC Analysis

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 a more significant issues.

ABC’s method of control helps in managing inventory effectively. Efficiency by reducing cost, which in turn contributes to revenue.

Abbreviation

ABC in ABC analysis stands for Always Better Control.

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.

Pareto’s law

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.

Pareto analysis

It is a synonym for ABC analysis. This analysis classifies items into different categories depending on their annual usage.

Pareto distribution

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 or 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 needs

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 use 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:

  1. Determining the annual usage for each inventory item for one year
  2.  Inventory Items are listed in descending order based on yearly usage value
  3.  The percentage of the total usage value for each item is calculated
  4.  The average inventory of each item is calculated by dividing the usage value by two and several orders.
  5.  Arrange these items in the stock by cumulative annual usage and cumulative percentage.
  6.  Group these items as Category A, B, and C.

i.e., 

Annual usage = Unit cost of the item * Annual usage quantity.

ABC Categories

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.

Categories of ABC Analysis

Group ‘A’ items are 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. Category C items are known as trivial many.

Group A items will get more attention and importance.

Categories of ABC Analysis

Advantages

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.

Disadvantages

  • 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.

Graphical representation

Graphical representation of ABC Analysis

Best practices of ABC Analysis

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

Conclusion

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.

Reference

Information about ABC analysis