ABC Analysis

What is ABC analysis?

ABC analysis is a prioritization technique based on the Pareto Principle or the 80/20 rule. This rule suggests that 80% of the total output is generated only by 20% of inputs. Similarly, in a business, maximum output (sales) is generated by a few critical inputs (inventory).

ABC analysis categorizes items based on their output or contribution. It is used in the inventory management system. It helps identify the inventory, which contributes the maximum to sales.

 

How is it applied in an inventory management system?

Under ABC analysis, the inventory is classified into three categories. These categories are based on the contribution of the inventory to the total sales.

Category A: Inventory under this category contributes the maximum to sales. Hence it requires tight monitoring. This type of inventory might be low in count, but high in value. 

Category B: Inventory under this category contributes lesser to sales than in Category A. It is also higher in count and requires moderate monitoring.

Category C: Inventory under this category contributes the least to the sales and requires the lowest monitoring. It might be the highest in the count, but its value in the business is the least.

 

Why is ABC analysis critical?

ABC analysis helps a company focus on inventory items more critical to sales. Accordingly, the company can allocate more time and resources to these items.

Following are some benefits ABC analysis offers:

• Helps in purchase function: ABC analysis helps a seller identify the contribution of various inventory items in sales. Thus, a seller can decide what to buy and in what quantity. This process also reduces the risk of obsolete inventory.
• Better control: ABC analysis helps in exercising better control in inventory management. For example, inventory under Category A can be counted monthly, category B quarterly, and category C once in six months.
• Efficient use of resources: After ABC analysis, the seller can invest more money to purchase Category A inventory items. Further, the company can use allocate workforce for the management of this inventory category. More space in the warehouse can be dedicated to it.
• Negotiation with suppliers: ABC analysis helps the seller identify the inventory items in which most of the money is invested. Hence, it helps negotiate terms with the suppliers. This, in turn, helps in cost reduction and results in better profits.
• Pricing: ABC analysis guides in pricing. Category A inventory is high in demand and hence can be priced accordingly. 
• Lower stock-outs: When the seller knows which is the most critical inventory, they can maintain a higher stock level. Hence, the chances of stock-outs during high demand reduces.
• Improved customer satisfaction: ABC analysis helps the seller reduce stock-outs and improves production efficiency. This results in quicker deliveries and improved customer satisfaction.

 

How to do ABC analysis? 

• The first step is to decide the criteria on which the company will make the categories. The most frequently used criterion is the contribution of inventory to sales.
• Once the company decides the criterion, the next step is to collect the available inventory data for analysis.
• The next step is to sort the inventory data, based on the decision criteria, in decreasing order of impact. For example, when contribution to sales is the criteria, rank the inventory items from highest contribution to sales to lowest.
• Once data is sorted, divide your inventory into categories based on your preferences.
• Continually monitor the sales of different inventory items to ensure that their places in ABC analysis are correct.

 

Let us understand the above with the help of an example:

Sam has a chocolate manufacturing business. He manufactures 5 types of chocolates. He decides to categorize his inventory items based on their contribution to annual sales.

He has sorted his inventory data in descending order of contribution to annual sales:

Products	No. of units sold annually	Sales value per unit (USD)	Annualsales value (USD)	% contribution to annual sales	Cumulative % contribution to annual sales
Chocolate 1	20	15	300	42%	42%
Chocolate 2	22	12	264	37%	78%
Chocolate 3	25	5	125	17%	95%
Chocolate 4	40	0.50	20	3%	98%
Chocolate 5	50	0.25	12.5	2%	100%

Based on the above table, Sam can decide the limits of categorization into A, B and C categories. There are no specific rules for determining these limits. However, for the above example, Chocolate 1 and 2 can be classified in Category A, as they constitute 78% of the sales. Sam can classify Chocolate 3 in Category B and Chocolate 4 & 5 in Category C.

 

Conclusion:

ABC analysis helps in the prioritization of inventory based on their importance. With this, the company can allocate more time and resources to the essential items. This keeps costs under control and increases profits. However, there are no set rules for such categorization. Companies need to decide the limit for each category based on what is meaningful to their businesses.