ABC analysis is an inventory management principle which stands for Always Better Control. It is based on the Pareto principle (20% of a commodity accounts for 80% of the net result) and can be very useful for management of a company’s inventory. In this article, we consider what ABC analysis is exactly and how it is calculated, an example of it in action and some pros and cons of its implementation.
The ins and outs of ABC analysis
ABC analysis is based on the Pareto principle also known as the 80/20 principle or the law of the vital few. Whatever you call it, the fundamental basis to it is that 80% of the effects come from 20% of the causes. In inventory management, this can be reworded to say that 80% of revenue is attributable to 20% of inventory.
The analysis part of this involves dividing your inventory into three categories representing the most valuable (A), inventory of moderate value (B) and the least valuable (C). As you can probably guess, the 20% of inventory accounting for 80% of revenue is category A. Category B should comprise approximately 30% of inventory and category C should comprise approximately 50%.
To actually categorise your inventory, you will need two sets of data:
- The demand or annual usage of each product line in inventory
- A metric you are aiming to improve for each item (e.g. revenue or purchasing costs)
For the revenue metric, you will need to assess your sales data and ascertain which products account for 80%, 15% and 5% respectively of your sales revenue. This essentially ranks your inventory in terms of importance and allows you to manage it accordingly. However, it is also important to not be too rigid as products can and should change categories as their life cycle evolves.
The next question to bear some thought is how these categories then impact your inventory management decisions and activities. Well, Category A for example, which accounts for 80% of revenue should be managed more carefully which may well mean more frequent physical stock counts and manual acceptance and fulfilment of orders to ensure accuracy is maintained. Category C, for example, does not require as close monitoring and could be managed automatically through the inventory management software as any possible errors with ordering can be more easily absorbed and have smaller long-term ramifications.
A real-world example
An example of ABC analysis in action is for a device manufacturer. They may categorise their high-value items such as mobile phones or cameras as category A items. They are very important, worth a lot but make up a smaller component of inventory.
Genuine replacement components such as screens, motherboards and lenses may be categorised as B items where they are not quite as valuable but still hold some value and should be managed accordingly.
Accessories such as cases, earphones, screen protectors and add-ons could be denoted to category C where they are low-value items but account for the vast majority of inventory.
To understand tapering management to category type, if a mobile phone case in pink was not available because of improper management, it likely will not sour the customer relationship and have any dire ramifications. Furthermore, rectifying the situation would be as simple as ordering more. However, if a particular mobile phone was not available it would certainly affect the company’s reputation and would take longer to order in.
Pros and cons of using ABC analysis in your warehouse
Pros of ABC analysis include having a tight grip on high-value items that can be extremely costly to the company if they were ordered erroneously or not stored or controlled properly to optimise their shelf-life and value. This also enables the inventory manager to prioritise their time so that they are not wasting precious time on managing items that have a far lesser worth. Of course, time is money and any production or labour time associated with the items adds to their cost of goods sold (COGS). If these items are not high-revenue-earning products, then this cost may not be gained back if too much time is spent on them.
Cons of ABC analysis include making decisions based on inventory value and importance rather than frequency of sale or the movement of SKUs, equally important metrics for overall management.
With ABC analysis, it is also very easy to consider products in categories B and C as not needing much attention, which can quickly result in them being neglected, stockpiling and subsequently becoming susceptible to loss, theft, expiration or obsolescence which decreases their value further and costs the company significantly.