What is ABC Analysis?

ABC Analysis also referred to as ABC Classification, is an integral part of

material management. It is an inventory categorization method, which
classifies the inventory primarily into three distinct categories based on
the revenue generation. ABC inventoryhelps business entrepreneurs and
stock owners identify the essential products in the stock and prioritize
their management based on the value. The inventory analysis is based on
the Pareto Principle.

The Pareto Principle is a popular economic theory, discovered by

renowned Italian economist Vilfredo Pareto. Pareto believed that optimum
economic growth occurs only due to a small part of the economy. It
means that the relation between the input and output is always unequal.

Pareto Principle states that 80% of the sales volume gets generated from
the top 20% of the items. It says that in any group, there are significant
few and insignificant many. It is also known as the 80/20 rule.

Category of ABC Analysis

ABC Analysis is based on the theory that all inventory items cannot have
similar or equal value. Hence, the three categories include-

If one implements the Pareto Principle to ABC Analysis, then A consists of

20% of the total products with almost 80% revenue generation. Hence, it
demands a robust and consistent control. B regulates approximately 30%
of the goods with 15% revenue, while C has the lion's share controlling
almost 50% of the stock but only powering 5% of the total revenue. Hence
the stock managers are quite lenient while calculating this category of
inventory.

ABC Analysis Graph

The two pyramids represent the ABC Analysis Graph.

The first pyramid suggests the percentage of the total number of

inventory items. Here Category A comprises only 10% of products, B
contains 20% items, and C has the maximum number with 70% of
products.
Similarly, if one perceives the second pyramid representing the
percentage of average inventory value, the structure reverses. Here, A
gains the spotlight with almost 70% of inventory value and revenue
generation, while B retains its mid-level spot controlling 20% of inventory
value. C only generates 10% of revenue; hence it has limited control.

In short, A signifies most important, B indicates moderately

necessary, and C denotes least essential inventory goods.

How to Calculate ABC Analysis?

A stock manager can perform ABC calculations on both individual product
groups or a wide range of inventory. An ABC Calculation is usually carried
out within five steps, which are as follows-

1. First, multiply the annual number of products with each item's cost
and find the utility of that product.
2. Make a category of every product in the descending order based on
its usage value.
3. Add the usage value of the products, including the total number of
items.
 4. Find out the cumulative percentages of items sold and annual
consumption value.
5. Now, it's time to divide your data into three categories, finally, in an
approximate ratio of 80:15:5.

Example of ABC Analysis

ABC calculation has been further illustrated through an example
containing a few tables.

One can take the example of a Furniture Store.

Step 1: Multiply the total number of items by the cost of each unit to find
the annual usage value.

Step 2: After noting all the products of the inventory, it’s time to list them
in the descending order based on annual consumption value.
Step 3: Sum up and add the total number of units sold and the annual
consumption value.
Step 4: Find out the cumulative percentage of products sold along with
the percentage of annual consumption value.
Step 5: In the last step, split the data and numbers into the three A, B,
and C categories. Remember, it’s essential to set the data in the ratio of
80:15:5.
The table shows that items listed in Category A generate approximately
79% of annual consumption value, B yields 13%, while C generates 8%
revenue.

The Salient Features of ABC Analysis

It’s essential to highlight the pivotal features of all the three categories viz
—A, B, and C on a separate note. Have a look at the image below.
Why is it Critical to Use ABC Analysis for Inventory
Management?
Many organizations have massive Stock Keeping Units or SKUs, but it
hasn't helped them to flourish and upscale their business. Furthermore,
there are various other inventory managementchallenges that a business
entrepreneur has to tackle. It may include inadequate knowledge about
the stock, inefficient management process, finding problems in managing
people and space, and more.

Inventory classification is a viable solution that can help enterprises

streamline their inventory management process. As the name suggests,
inventory categorization is a method to strategically set the price of
various products based on their demand value. The ABC method of
inventory is a classification technique that helps stock managers resolve
all concerns related to maintaining inventory and maximize the inventory
value of the goods.

1. Analyze the Customer Demand for a Particular Product

Category
Every product must pass through four main stages; launch, growth,
maturity, and then declination. When a product gains optimum value, it
inevitably sinks at a certain point in time. It is known as the lifespan of a
product.
It is essential to note that the lifespan of a product depends on the
customer demands. It is here that ABC inventory classificationgains the
spotlight as it helps business enterprises in precisely analyzing customer
demands. The business owners and inventory managers can analyze the
consumer needs of a specific product and manage their inventory
accordingly. If the market for an item escalates, the downfall period gets
pushed further.

2. Streamlining and Optimizing the Inventory Process

One of the significant. Unique Selling Points or USPs of ABC Analysis is
streamlining and optimizing the inventory management process. It helps
inventory managers to organize and segregate stock based on their
annual consumption value and revenue generation. The products can also
be categorized based on customer demands.

3. Conducive Negotiation with the Supplier

ABC Analysis is also useful in getting a conducive negotiation with the
supplier. For example, if an enterprise is negotiating with the suppliers of
A category products, it has to make a maximum investment there since it
offers maximal revenue. Even if the business is making a lucrative offer,
there are chances that the supplier is still unwilling to strike the deal.

In such a scenario, the business can still seal the deal by offering other
benefits such as lowering the down payment and providing free shipping.
It helps to create a favorable win-win situation for both parties. It also
allows businesses to save more on A category products and reaping more
profits.

4. Strategic Pricing of the Products

ABC inventory analysis also allows organizations to set the price of various
products strategically. It enhances the inventory value of the products.
Once the cost of the products is set strategically, it becomes relatively
easier to align them based on different categories. If the demand for the
product increases, the seller can hike the price.

5. Enhancement in Customer Service Levels

The warehouse managers can stock the products based on their value and
importance. It means that they do not need to overstock any such items
that are not sold regularly and have a low margin. Here, ABC Analysis can
play a pivotal role in helping inventory managers set service levels based
on categorizing the items. It further streamlines the supply chain
management process.

6. The Allocation of the Resources

An inventory manager has to give a special status to A-class items and
focus on that specific category. But if he finds that the demand for A
category items has reduced and that it is no longer generating higher
revenue, the products are demoted to a lower category.

How to Conduct an ABC Analysis?

A business organization can conduct a precise ABC Analysis by ensuring
the following steps-

 Find out what needs to analyzed and anticipate the success

ratio
When a business conducts an ABC Classification, it has two prime
objectives. First, to ensure that supply costs are highly competitive and
second to boost the cash flow by storing high demanding products in the
stock.

 Gathering Data for Analyzing

If the company uses an inventory management system or accounting
software, it can easily collect vital data related to various stock items.
Plus, it can also gather information on its annual expenditure, orders and
purchases, transportation costs, and more.

 Rank the Inventory in Descending Order

Next, it's essential to classify or organize the inventory in the descending
order. Place the maximal-priced product on the top and the minimal-
priced item at the bottom. Even during cycle counting - a process where
high inventory accuracy can be maintained throughout the year can be
done using the ABC method.

 Calculating the Cumulative Impact

Now make a note of all the products and add them in a spreadsheet. It's
time to calculate their cumulative effect on the business. The products are
divided into two columns; the total number of products sold and their
annual costs. Take out the cumulative percentage of annual usage value
to categorize the inventory.

 Classify the Inventory Based on the Demand

It is at this stage that one needs to apply the Pareto Principle. It's not
necessary to use the 80/20 rule, but it's essential to take a few pivotal
measures. The steps include conducive negotiation with the suppliers,
framing a product price strategy, ensuring the optimal value of the
products, and more.

 Monitor the Categories and Allocate the Products

Accordingly
It is the last step where managers have to keenly analyze the categories
and then allocate the products based on revenue generation. It means
that an item minting the highest money will peak the class. But it contains
only a few product sources. On the other hand, the ones providing lower
returns will drop down the list. Besides that, the managers need to
continuously keep an eye on pricing, customer demand, and product
performance.

Major Applications of ABC Analysis

The Manufacturing Sector
ABC Inventory Analysishelps manufacturers to improve the inventory
replenishment schedule. It allows managers to categorize stock items
based on the total annual cost. Also, ABC Analysis becomes mandatory if
the organization plans to integrate the Kaban to manage the workflows.

Supply Chain and Warehouse

The supply chain and warehouses use ABC Inventory Classification mainly
for the stock count cycles. For instance, items placed in category A have
to be counted quarterly. B class items need a bi-annual counting. On the
other hand, C category products get the most liberty. They are calculated
on an annual basis, once in a year.

Retail and E-commerce

The retail and the e-commerce industry usually choose ABC

Managementfor customer segmentation. It helps retailers and e-
commerce owners to pinpoint their most valuable customers. ABC
Analysis is performed using key metrics such as sales revenue, buying
potential, and contribution margin. The retailers can create a chart based
on the metrics and then rank their customers in A, B, and C categories
accordingly.

Logistics Industry

The logistics industry is also reaping the benefits of ABC Analysis. Here
ABC management plays a pivotal role in controlling the inventory. The
products are classified according to their importance based on different
criteria such as sales ratio, profit margin, and cost of transportation, etc.