This article was updated in March 2023 to reflect current industry trends, data, and pricing.
Whether you’re a manufacturer, a retailer or a trader, it’s important to keep on top of your inventory. Everything in your inventory has value – you’ve invested time and resources and money into each and every item, and you’ve done that because each and every item is worth something to someone else.
If you aren’t practicing proper inventory control, inventory stock might get stolen, goods might go missing and you might have to carry out tedious, expensive stocktaking processes to get everything back in order.
Poor inventory control is expensive, especially if you sell or trade in a wide range of, or a high volume of, products. That’s where ABC analysis comes in.
What is ABC analysis?
ABC analysis is a way of organising your inventory based loosely on the Pareto principle. You might know that principle better as the 80/20 rule, which holds that when it comes to a large number of events, roughly 80% of the effects come from 20% of the causes.
For example, if you’re working on a project in your backyard, about 80% of the project will be completed in 20% of the time you spend on that project.
How does ABC analysis work?
When applied to inventory stock, the principle holds that approximately 80% of your inventory’s value comes from 20% of your products. The ABC system helps you identify that 20% of inventory stock and organise your inventory around it.
ABC analysis works like this:
- Start by counting up how much of each product moves through your inventory each year.
- Once you have your final numbers, work out how you want to value each product. Do you want to bring down unit purchasing costs for an item? Do you want to improve profit for that item? This metric is relevant to the next step…
- …in which you categorise each item based on their value to your business.
- A classified items are high value – they might be the most expensive items you’re purchasing or the ones that yield the highest profit
- B classified items are in the middle – not as valuable as A, but more valuable than C classified items
- C classified items, which are typically high volume, low-value items
Benefits of ABC analysis in inventory management
The idea, then, is that you organise your inventory control around these classifications.
For example, you might store your A classified inventory in the most secure area of your store or warehouse and audit it more frequently in order to make sure it’s secure and that nothing’s been stolen or neglected.
On the flipside, you might manage your C classified inventory more loosely, with less detailed records and with fewer controls. But what are the benefits of organising your inventory stock under the ABC classification system?
The benefits of using ABC analysis for inventory management include:
- Save money by focussing your resources on controlling and protecting the inventory that is most valuable to your company. Instead of wasting time and resources on regular counting of C classified items, for example, you can direct that energy toward proper management of A classified items.
- Better identification of what products you can afford to understock, and you can predict with more accuracy what products you need to have in your stock room at all times.
- Manage your stock room better in order to save time and better protect your high-value stock. For example, you can store C classified items at the front of the stock room in order to save your staff time rummaging around the stock room looking for these high volume items.
Drawbacks of the ABC system
The ABC system also has some potential downsides that you should be aware of before implementing it in your business.
Fundamentally, the ABC system is not an empirical system – rather, it’s a loose classification system based on your own hunches and intuitions, no more or less evidence-based than rating your favourite movies.
However, you know best what is most valuable to your business, and the ABC system is purposefully flexible so business owners can organise their inventory around what is most valuable to them.
The ABC system might encourage you or your staff to ignore the less valuable B and C classified items. This could lead to you losing money and inventory through deterioration of your product or through theft from inside or outside your business.