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What is ABC Analysis & how it is used in inventory management

Updated: Sep 8

Introduction

Most businesses consider inventory management to be one of the most challenging and time-consuming jobs. On the other hand, inventory management is critical for all types of businesses, including manufacturing, retail, e-commerce, logistics, and many more. It assists business owners in maintaining optimal stock levels and avoiding stock-outs. ABC Analysis is one of the most effective strategies for helping managers improve inventory levels.

Understanding ABC analysis

ABC Analysis, often known as ABC Classification, is an important component of material management. It is a system of inventory classification that divides inventory into three separate groups depending on income-generating. ABC inventory assists business owners and stockholders identify the essential items in their inventory and prioritise their management based on their worth.

The Pareto Principle is used to conduct the inventory analysis. The Pareto Principle is a well-known economic theory developed by Vilfredo Pareto, a renowned Italian economist. Only a small fraction of the economy, according to Pareto, produces optimal economic growth. It implies that the input-output relationship is always uneven.

According to the Pareto Principle, the top 20% of the goods produce 80% of the total sales volume. It states that there are significant few and inconsequential many in any organisation. The 80/20 rule is another name for it.

ABC analysis categories

The ABC Analysis is based on the idea that no two inventory items may have the same or equivalent value. As a result, the three categories are as follows:

  1. Category A: Items grouped under A in the ABC model of inventory control have the highest yearly consumption value. It's worth noting that just approximately 10 to 20% of the total inventory products account for the top 70% to 80% of the company's annual consumption value. As a result, prioritising these issues is critical.

  2. Category B: These are goods with a moderate consumption value. These makeup around 30% of a company's entire inventory, accounting for about 15% to 20% of yearly consumption value.

  3. Category C: This group contains the products with the lowest consumption value, accounting for less than 5% of the yearly consumption value, which comes from around half of the total inventory items.

Calculating ABC analysis

ABC computations can be performed on specific product groups or a large amount of inventory by stock management. In most cases, an ABC Calculation is completed in five phases, as follows:

  • To determine the usefulness of a product, multiply the yearly number of goods by the cost of each item.

  • Make a descending order category for each product depending on its usage value.

  • Add the total number of items to the use-value of the products.

  • Calculate the total number of goods sold and the annual consumption value.

  • Finally, split your data into three groups in the ratio of 80:15:5.

Using ABC analysis for inventory management

Many businesses have many Stock Keeping Units (SKUs), but this hasn't helped them grow and expand. There are also a variety of additional inventory management issues that a business owner must deal with. It might involve a lack of stock knowledge, inefficient management procedures, issues with personnel and space management, and more. Inventory categorisation is a potential option for businesses looking to streamline their inventory management. The ABC method of inventory is a categorisation approach that assists stock managers in resolving all inventory issues and maximising inventory value.

  • The ABC Analysis' unique selling points, or USP, including simplifying and optimising the inventory management process. It assists inventory managers in organising and categorising goods depending on annual consumption and income-generating. Customer requests may also be used to classify the items.

  • ABC inventory analysis also enables businesses to establish prices for particular items strategically. It increases the product's inventory value. It becomes comparatively easy to align items based on distinct categories after the production costs have been carefully determined. If the vendor sees a rise in demand for the goods, they might raise the price.

  • Launch, growth, maturity, and decline are the four key stages that every product must go through. When a product reaches its maximum value, it will surely drop at some point in the future. The lifetime of a product is what it's called. It's important to remember that consumer expectations determine a product’s lifecycle. ABC inventory classification takes centre stage here since it aids businesses in accurately evaluating consumer wants. Business owners and inventory managers may assess a product's consumer demand and manage their inventory accordingly. The falling time is stretched farther if the market for an item rises.

  • An inventory manager must offer A-class products a special status and concentrate on that category. However, if he discovers that demand for A category items has decreased and that they are no longer earning more income, he will demote them to a lower category.

  • ABC Analysis may also help you reach an amicable agreement with your supplier. For example, if a company is negotiating with suppliers of A category items, it must invest the most money possible since it gives the most profit. Therefore, evenefore, even if the company makes a reasonable offer, there's a risk the supplier would refuse to do business with them.


ABC analysis

Conducting an ABC analysis

A corporate entity can follow the following procedures to conduct an accurate ABC Analysis:

  • Find out what has to be studied and what the success rate is likely to be.

When a company does an ABC Classification, it has two main goals. First, to guarantee that supply prices are competitive, and second, to increase cash flow by keeping high-demand items on hand.

  • Data Collection for Analysis

If the firm utilises an inventory management system or accounting software, essential data about various stock products may be quickly collected. It may also collect data on its yearly spending, orders and purchases, transportation expenses, and other things.

  • Sort the items in descending order.

The inventory must then be classified or organised in decreasing order. Place the highest-priced item on top even before the lowest-priced one at the bottom. The ABC technique may be used even during cycle counting, which is a practice that maintains excellent inventory accuracy throughout the year.

  • Cumulative Impact Calculation

Make a list of all the items and enter them into a spreadsheet. Then, it’s time to figure out how much of a difference they'll make in the long run. The products are separated into two columns: total number of units sold and annual expenses. To classify the inventory, subtract the cumulative proportion of yearly consumption value.

  • Sort the inventory according to the demand.

It is at this point that the Pareto Principle should be applied. It is not required to use the 80/20 rule, but following a few key steps are critical. Conducive negotiating with suppliers, establishing a product pricing plan, guaranteeing the items' best value, and more are among the processes.

  • Keep an eye on the categories and make product allocations accordingly

Managers must carefully examine the categories and then assign items depending on revenue creation in the last phase. It indicates that the item with the most money will be at the top of the class. However, it only has a few product suppliers. Those with lesser returns, on the other hand, will be pushed down the list.

Application of ABC analysis

  1. The ABC Inventory Classification is mostly used in the supply chain and warehouses for stock count cycles. Items in category A, for example, must be tallied every three months. A bi-annual count is required for B class products. C category items, on the other hand, have the most flexibility. They are computed once a year on an annual basis.

  2. ABC Analysis is also beneficial to the logistics business. In this case, ABC management is critical to inventory control. The goods are categorised according to their relevance using several factors such as sales ratios, profit margins, and transportation costs, among others.

  3. Manufacturers may use ABC Inventory Analysis to optimise their inventory replenishment plan. It enables managers to classify stock goods according to their total yearly cost. ABC Analysis is also required if the company intends to use Kaban to manage processes.

  4. Customer segmentation is often handled by ABC Management in the retail and e-commerce industries. It aids retailers and online merchants in identifying their most valued consumers. Key indicators including sales revenue, buying potential, and contribution margin are used in ABC Analysis. Retailers may use the information to construct a chart and then categorise their consumers into A, B, and C groups.

Conclusion

ABC Analysis is one of the most effective methods for business owners and inventory managers to classify their inventories according to their worth and revenue potential. They can focus on essential make-up items and keep track of their pricing using the ABC inventory technique. It also aids in inventory management, allowing firms to plan their spending properly.


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