What is ABC Analysis? ABC analysis (sometimes called Pareto classification) is a simple but powerful tool for prioritizing and inventory management.

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.

This article will discuss what ABC analysis is and how to put it into practice in your own business.

What is an ABC analysis?

ABC Analysis

ABC analysis definition

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.

It can help you make better decisions about your stock and improve your overall inventory management process. Keep reading to learn more!

ABC analysis concept in inventory management systems was first introduced by General electric in 1951.

ABC analysis aims to determine the level of control and frequency for each item in order
to optimize inventory levels.

Optimization can be done by identifying areas where there may be errors with particular items, such as raw materials that do not meet specifications, then implementing corrective actions before these mistakes become major issues affecting your company’s production capabilities.

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.

Related terminologies

Pareto’s law

An Italian economist Vilfredo Pareto developed this law 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 a small percentage of a group determines the vast majority of a result.
The result here may be wealth, cost, quality problems, etc. 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 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 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 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 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 crucial as it helps decide how much effort and cost has to be put into different inventory items.

ABC Analysis helps decide the degree of control required for each inventory item.

In the ABC analysis method, ‘A’ category items are valuable and have less 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 controlling these items.

This way, the application of ABC analysis helps identify and control items that significantly impact total inventory cost.

How to use ABC analysis in inventory management?

ABC inventory analysis is a profitability analysis of an inventory item. It’s performed by calculating the total annual cost and recognizing the average sale price per unit for each item.

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 annual usage value
  3. Percentage of total usage value for each item is calculated
  4. The average inventory of each item is calculated by dividing the usage value with two and a number of orders.
  5. Arrange these items in the inventory 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.

Categories of ABC analysis

It classifies inventory items into three groups. First, all inventory items are rated from A to C and grouped as 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.’ 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.

Group A item will get more attention and importance.

Categories of ABC Analysis

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.
  • It also helps in financial forecasting and planning for the coming year.
  • It helps to assign the resources as it continuously validates the allocation of resources and makes sure that class A items line up with customer demand.
  • It helps to identify the profitable item and hence 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 A, B, C classes.

Disadvantages of ABC analysis

  • ABC classification is based on the monetary value of the items. Though consumption value or economic values are negligible for some items, they could be vital for production.
  • It needs periodic updates and reviews. These reviews are needed 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 is not easy to calculate its value.
  • ABC analysis is not suitable for organizations that have stable annual consumption value of inventory by type.
  • To perform ABC analysis for more inventory items, organizations should buy special equipment and hire more staff.

Graphical representation of ABC analysis

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, give 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 (KPIs) 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 time of inventory from one location to another location.

Re-cotegorization 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, and hence 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 have an easy retrieval process of inventory, 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 Pareto classification, which says that 80 percent of your problems come from 20% of your causes. This means that 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 ABC Analysis to understand where the company will have the biggest return on investment (ROI).

For example, if you’re trying to maximize profit margins, it would be wise for you to invest in high-margin items and make sure you don’t overstock lower-margin items because they take up space needed elsewhere.

ABC analysis 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.

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