ABC Analysis – Prioritize your Inventory

Time to read: 5 Minutes
ABC-Analysis

In inventory management, it can be pretty challenging to deal with several suppliers and thousands of parts. That is why your organization’s personnel must find a way to deal with items in terms of priority and their impact on inventory cost. This is where ABC analysis comes in.

This article covers this type of analysis in detail to equip you with all the information on this inventory categorization tool and help you perform the analysis.

ABC Analysis - FAQs

ABC analysis involves three segments, A, B and C. Therefore, items that fall under segment C are slow-moving items, thus, should not be re-ordered in the same frequency as those in the segment and segment B.

Putting goods into these segments is beneficial to both distributors and wholesalers as it helps them identify items that should be replaced or stocked.

ABC analysis is used in stock checking, inventory system and supply chain management and acts as a cycle counting tool. It is vital for businesses that seek to reduce their carrying costs and working capital. This is achieved by analysing inventory, which is in excess stock and the obsolete ones by paving the way for readily sold items. This will aid in availing working capital for use instead of keeping it tied in unhealthy inventory.

When a business can control its stock and facilitate high-value goods, it enables them to keep track of assets value held at a time. It also introduces the order to a re-ordering process, ensuring that items are in stock and meet the public demand.

  • ABC analysis requires proper standardisation for materials stored for it to work and yield successful results.
  • ABC analysis requires a good coding system of materials in operation for it to work.
  • ABC analysis takes into account the monetary value of items and ignores other factors that may be more beneficial for your business.

The ABC model categorises goods in A, B and C. Goods in A record the highest value regarding annual consumption. Items in B have a medium consumption value amounting to 30% of the entire inventory. Items in category C have the lowest consumption value hence account for just 5% of annual consumption. With this in mind, supply managers should prioritise items with the highest value and minimise those with low value.

Definition: ABC-Analysis

ABC analysis is a technique used in materials management and is used to categorize inventory. It divides an inventory into three categories A, B and C items, where A- items have a very tight control with accurate records and B-items have less tight control and good records. C-items have as simple as possible control and minimal records.

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What are the steps in ABC analysis?

ABC-Analysis Calculate the yearly usage

Calculate each item’s yearly usage value by multiplying the annual demand by item cost per unit.

ABC-Analysis Arrange your Items

Arrange your items in descending order of the calculated usage value.

ABC-Analysis Form a comulative sum

Form a cumulative sum of the usage value and the number of items.

ABC-Analysis Convert your comulative sum

Convert your cumulative sum of items and usage value to a percentage of their totals.

ABC-Analysis Draft a graph

Draft a graph that links cumulative % usage value and cumulative % items. The graph is partitioned to approximate three parts, where the curve changes its shape sharply. This shows all the three parts A, B and C.

The procedure explained in detail:

ABC analysis upholds that a business organization must rank its items based on A to C during their inventory evaluation, basing its ratings on the rules that A-items are taken as goods consumed yearly and whose value is greatest. B-items have an average use value and are taken as interclass items. Therefore, 15 to 25% of the annual use-value will include 30% of the whole stock items.

Using a formula, you can calculate annual consumption cost by multiplying the annual demand with the item cost per unit (Annual demand) x (item cost per unit). With this, a business entity’s supply manager can classify inventory hot spots and split them from the remaining products, specifically those abundant though not money-spinning for the organisation.

Therefore, items with maximum annual usage are ranked high and those with minimum annual use are ranked lowest.

Policies derived from the ABC analysis impact the sales difference given in the Pareto principle. This implies that all products should be evaluated according to their category. A-items should follow strict inventory control, high sales forecasts and extra shielded storage spaces. There should be a regular re-order every week or daily. A priority function for A-items is to handle the misfortune of running out of stock. Re-ordering is not highly observed in C-items.

They show low demand and high risk of pointless inventory expenses, a technique that causes a stock-out position and purchases that may be an appropriate state. Therefore, C-items’ main question is not the number of units to be kept in store but whether there is a need to maintain it in store. When it comes to B-items, they facilitate from a middle position between A and C. an important feature in the B category is examining potential growth to the A category or towards C category.

Good to know: If you want to learn more about other methods & concepts, click the link!

Why use an ABC analysis?

ABC analysis is an important tool for businesses since it helps them maintain control of costly items and require a large capital to invest in. Besides, the technique aids in reducing or avoiding storage expenses and helps businesses maintain an optimum level of stock at all times, which helps reduce staff expenses.

ABC analysis ensures that the stock turnover ratio is kept at a higher level through systematic inventory control. Furthermore, it gives room for the maintenance of enough C items without compromising important products.

ABC analysis: example

You can easily use the analysis in terms of customer segmentation. This will help you gain a broader understanding of the market and at the same time enable you strategise for the future. You can base this on four major metrics: support costs, contribution margin, sales revenue and revenue potential.

Implementing ABC analysis for your customers

The best way to do this is by beginning to create charts, basing them on the four primary metrics. After you finish, you can go ahead and compare them, focusing on contribution and sales revenue charts. Afterward, rank these customers then put them into categories – A, B and C.

  • Class A: Put your most valued customers here
  • Class B: The most loyal customers will come here and they will spend a considerable amount of money
  • Class C: There rest of your customers will fall here automatically

Based on my parameters, Class A customers are the most valued because they can easily bring in significant revenues, which contribute immensely towards the contribution margin. On the other hand, Class B are the loyal ones. These set of customers will often spend on regular intervals but don’t spend that much compared to Class A. Finally, Class C customers turn up infrequently or frequent once but often make small purchases. Therefore, they don’t exactly contribute much to the overall sales or profits.

In a Nutshell

  • ABC Analysis is simply an inventory categorisation tool.
  • ABC Analysis classifies items into three categories, A, B and C.
  • A-items are of high value in annual consumption.
  • B-items are of moderate value in annual consumption and C-items are of lowest value in annual consumption.