ABC analysis is derived from the term “The Pareto Principle” named after an Italian economist Vilfredo Pareto, also called as 80/20 rule. This principle suggests that 80% of the total output is generated only by 20% of the valuable efforts.
When it comes to stock or inventory management, ABC analysis typically segregates inventory into three categories based on its revenue and control measures required: A is 20% of items with 80% of total revenue and hence asks for tight control; B is 30% items with 15% revenue; whereas ‘C’ is 50% of the items with least 5% revenue and hence treated as most liberal.
Any particular company’s numbers may be different but have a similar distinguishable pattern. This analysis aims to draw managers’ attention on the critical few (A-items) and not on the trivial many (C-items) and focusing its inventory control efforts on those particular items where it will have the greatest effect.
As a purchasing manager, understanding your sales over a certain period of time will help you evaluate and segregate which product belongs in which category i.e. A, B, or C. This will also assist the purchase manager to analyze what to buy, and in what quantity.
Category A is the smallest, always reserved for the biggest money makers. It represents the highest quality, most valuable products and customers that you have. Such products will contribute heavily to the overall profit without costing much when it comes to the seller’s resources.
Category B products are less important than Category A products and more important than Category C products. So stay in the middle. This category, in particular, holds the potential to either get moved into category A if the sales are good, or can even slip down to category C.
Category C items are marginally important. These products will help you to continually run your business, with a definite and steady income, but don’t individually contribute much value to either the seller or to the business.
ABC Analysis of Customers
ABC analysis can also be performed for the customer or client base to understand the market and strategize your business plans. ABC analysis for customers can be based on four primary metrics: revenue potential, support costs, sales revenue, and contribution margin.
Example of ABC Analysis
Lisa has a business of sweaters, and over time, her business has achieved tremendous success. Lisa, in search for varieties and additions to her sweater inventory, has filled in 180 types of sweaters instead of just 50 types. She now realizes that this business is seasonal and she already has invested a lot. After thorough research on how the above-mentioned problem can be streamlined, Lisa implemented the ABC inventory categorization in her business model.
She was finally able to allow her business to visualize those areas wherein more profit was expected.
Now, as Lisa already had too many options to organize into three categories: Category A, B, and C, depending on their selling ratio, price, demand, etc.
Category A – The sweaters that fall under this category are the ones that are most important to the company. They can either be the ones that are highly in demand, the ones that are generating the most revenue, or the ones falling under the hottest trend for the season.
Category B – These sweaters are important to the company, but not as much as the ones in category A. A smaller market or lesser comparative demand are some of the reasons. For example, Christmas sweaters are mostly sold during the season and not very much before or after that. But yes, during the seasons, the sales do go up. Lisa can neither neglect such sweaters nor can she make much profit when not in season. Hence, category B.
Category C – This category includes the products that are neither in category A nor in category B. Lisa doesn’t wish to put in more efforts to sell off these sweaters as they are not of high value to the company. Odd sizing, color combinations, patterns can be the possible reasons for Lisa to put these sweaters in category C.
Why Use ABC Analysis?
There are 6 reasons why a business should opt for ABC analysis…
#1 End-of-life management
When it comes to a product, there is always a lifespan: launch, growth, maturity, and decline. The moment a product reaches the maturity stage, it might get declined sooner or later, but for sure. The entire lifespan of the product depends on customer demands. ABC inventory analysis helps a seller to analyze the customer demand for a particular category of product and then manage the stocks accordingly. The maturity and decline period for every product is different. More customer demand, the chances of declination are pushed further. Lesser the demand, sooner will it be declined.
#2 Supplier Negotiation
When it’s all about getting the category A products sourced, it is understood that 70-80% of the money is about to be invested in those suppliers. Negotiation is always a must. There are chances when a supplier might make a nod to your offer, but do not back off. You can always make offers like reducing the down payment, providing free shipping, etc. Try to make it win-win for both yourself as well as the supplier, and there are chances that you might just out winning the deal. Saving more on category A products can bring more profits to your business.
#3 Inventory Optimization
Inventory optimization is the most important reason why ABC inventory analysis is preferred by many businesses. to organize and segregate the products in the inventory as per their revenue and importance. The products are also categorized as per their demands amongst the customer base.
#4 Strategic Pricing
The ABC analysis of the inventory also brings in much more value to the company when the prices for the products are set strategically. With ABC analysis, the company will easily be able to strategize the prices of the products and then accordingly align them into different categories. More the demand for a product, wider will be the chances to increase the prices by the seller.
#5 Resource Allocation
While the process of resource allocation is done, category A is highly monitored. If it is noticed that the product from category A is not performing well or is no longer desired by the customers, it can be moved to a lower category i.e. either category B or category C.
#6 Customer Service Levels
There are several factors that can affect a product’s value or importance – item cost, quantity sold, and margin set. There is no need for unnecessarily crowding your warehouse with the product that has a low margin and is also not sold frequently. In such cases, the ABC inventory analysis clearly lets the planners set service levels based on the product classification. This further makes the supply chain smoother, carrying no additional safety stocks.
How is ABC analysis done?
Again, there are six steps to understand how ABC analysis is done…
#1 Identify what needs to be analyzed and define the success criteria.
ABC is mainly to be done to achieve two primary goals – to make sure that the supplier rate is as competitive as possible (let that be in exchange for any facility that you are providing) and to increase the cash flow by having the perfect items in the list that your customers need.
#2 Collect the data from your inventory that has been analyzed.
Before you begin to analyze, collect some data that is already available through any accounting tool, related to the annual spends. This can include all the ordering costs, carrying costs, etc. if at all they are readily available.
#3 Sort your inventory in the decreasing order of impact.
Rank the items present in your inventory from the ones costing the most to the least.
#4 Calculate the accumulated impact.
Here, you need to list down all the items in a spreadsheet and calculate the cumulative impact they had on your business. This will be done by dividing the items and their annual costs. This later is added to the cumulative total of the percentage spent annually.
#5 Divide your inventory into buying classes.
Now, you need to bring the ‘Pareto Principle’ into action. Not to differentiate the products with the 80/20 rule exactly, but with the principle. You will have to negotiate your contracts with the suppliers, strategize the product prices, ensure the availability of valuable products, etc.
#6 Analyze the categories and decide accordingly.
The products with the highest revenue generation will remain on the top, whereas the ones with a lower revenue drop down. There are only ‘vital few’ products that can be the money makers for you, whereas the ‘trivial few’ will drop down in the list. You need to constantly keep on monitoring the pricing and the selling performance of the products to make sure that their positions are adequate.
When it comes to supply-chain and warehouse management, ABC inventory analysis is majorly used for the stock count cycles. For example, the category A products will be counted quarterly, as they are much more important and valuable, category B products can be counted twice a year, and in the similar fashion, category C products can be counted once in a year.
Stock counting not simply helps you analyze your highly valued items but also helps you to understand how frequently do they need to be replenished. The process of replenishment can also be called reordering, which depends on the category of products, as per their own decided controls.
Category C items should never be reordered in the same way as category B. This will unnecessarily tie up your money. Most of the wholesalers and distributors do not put this into practice and unfortunately get a large number of working capital tied up in unhealthy inventories and products.
ABC inventory analysis isn’t mandatory for businesses to apply in their supply chain management, but is highly recommended to avoid future unwanted errors and losses.
There is no such threshold for determining which products will go into which category, the company needs to decide the threshold for each category if they really want to interpret the data that is meaningful to their business.