What is ABC analysis?

For businesses that deal with high volumes of inventory, it’s helpful to find a way to classify the more profitable items. This is where an ABC analysis comes in, offering a way to manage inventory more efficiently according to logical priority.

Understanding ABC analysis

The objectives of ABC analysis are to save time and money, freeing up management to focus the company’s resources on the highest value goods.

To accomplish these objectives, this inventory ranking method divides all items into three categories: A, B, and C, in descending order of value. In other words, the highest value items would go into category A, followed by medium-ranking items in category B, and lowest value items in category C.

This inventory management method works with the assumption that not all items hold the same value. Some cost more to purchase, while others are used more frequently. Conducting an ABC inventory analysis lets you sort them out in order of value so you can prioritise what’s most important.

Theory and types of ABC analysis

There are a few different types of ABC analysis. Some will focus more on the monetary cost of each item, while others focus more on the supply and demand or usage rates. In any case, the objectives of ABC analysis follow what’s called the ‘Pareto Principle’ or ‘80/20 rule,’ which states that 80% of inventory costs come from 20% of inventory.

Here’s how this breaks down:

• A items: These big-ticket items might just make up 20% of your inventory, but they hold 80% of its annual value.

• B items: These make up 30% of your inventory but make up 15% its annual value.

• C items: These lower-value items make up the remaining 50% of your inventory but hold just 5% of its annual value.

The ABC analysis theory states that you should focus the most attention on the A items, since they hold the bulk of your inventory’s value. Interclass or B items also deserve some attention, with some controls to protect against loss. However, with C items the ABC analysis states that it’s not cost-effective to implement strict controls, because the risk of loss is not as important due to their low value.

All businesses will have different thresholds to define what fits in each category, and which types of inventory controls should be used to protect them.

ABC analysis procedure

Here’s a quick ABC analysis procedure to group your items into the A, B, and C categories:

1. Calculate inventory value by multiplying each item’s price by its consumption volume during the accounting period. Use the formula of (Item Cost x Annual Consumption = Inventory Value)

2. Sort your items from highest inventory value to lowest.

3. Calculate the percentage of total inventory value for each item. This can be found by using the formula of (Inventory Value / Sum of All Inventory Values = Item Percentage)

4. The items that make up the highest 80% of inventory value should be A items. Those that make up the next 15% should be B items. The remaining 5% will be the C category of items.

Benefits of ABC analysis in inventory management

It doesn’t take too much time to perform, but an ABC analysis can be quite fruitful particularly for those businesses that deal in large volumes of inventory. Here are a few of the main benefits of ABC analysis in inventory management:

• You can reduce losses by maintaining stricter controls over the higher-value A and B items.

• You can use your stock management resources more efficiently.

• Avoid wasting time on C items that don’t generate very much profit. Consider devoting more time and money to the A and B classes.

• Improve production efficiency with a greater understanding of what customers are buying.

By grouping inventory into three simple categories, you can gain greater insight into big-picture value.

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