ABC Analysis

Meaning


ABC analysis, Paretos law or 80/20 rule basically states that 20% of a given population represents 80% of a specific characteristic. The ABC tool is used to identify the vital few from the trivial many, according to a defined set of criteria (e.g. annual expenditure, number of orders, number of claims, occupied space in the inventory..)

Why ABC?


In actual practice, thousands of items are included in business as inventories. But all these items are not equally important. According to this technique, only those items of inventory are paid more attention which are significant for business. All items are classified into 3 categories A, B and C

Categorisation


In A category those items are taken which are very precious and their quantity or number is small In B category those items are reserved which are less costly than the items of category A but their number is greater In category C all those items are included which are low priced but their number is highest

ABC codes


"A class" inventory will typically contain items that account for 80% of total value, or 20% of total items "B class" inventory will have around 15% of total value, or 30% of total items. "C class" inventory will account for the remaining 5%, or 50% of total items..

Steps to perform ABC analysis



Identify the objective and the analysis criterion Collect data about the analyzed population Sort out the list by decreasing impact Calculate the accumulated impact and percentage Identify the classes Analyze the classes and take appropriate decisions

Example of ABC analysis in a Manufacturing organisation

Classification

In a manufacturing organisation, the items of inventory can be classified as under:Class A B C Number of items in terms of their % 15 30 55 100 % as per their value 70 20 10 100

Analysis

Category A & B


The number of items of category A are 15% but their value is 70% of total inventory. Therefore, inventory management can be made more effective by concentrating control on this category. Effort are made to minimise investment items of this category. The % of number of items in category B is 30 but their value is 20%. Therefore this category will be paid less attention.

Category C


The items in category C is 55% but their value is just 10% of total. Therefore, management need not spend much time for control of this class of inventory as very little investment is made in them. These items are purchased in bulk quantity once in 2-3 years. The management must be aware that these items may be less important in terms of value but their non-availability can break down the production process

Advantages

Advantages


A Close and strict control is facilitated on most important items which constitute a major portion of overall inventory valuation and due to this, costs associated with inventories maybe reduced. The investment in inventory can be regulated in proper manner & optimum utilisation of available funds can be assured. A strict control on inventory items in this manner help in maintaining high inventory turnover rates.

Managerial application


Used in three important managerial functions:



Planning Analysing Controlling

Other areas of application

       

Budgeting and monitoring performance Increasing Sales, Revenue and Profit Controlling costs and expenditure Expanding and diversifying Business Managing Growth of Product and Services Managing Growth and Activities of Offices and Retail Outlets Controlling Quality of Product and Services Portfolio Management

Limitations

Limitations


Most of the time only past annual spend is available to perform an ABC analysis. The use of past annual spend is fine if the business needs will not change in near future. The buyer may consider that next year figures will be the same as the last years one. In case where buyer considers that future needs may vary from past figures, it would be better, to use future annual spend provided by internal customers or budgeted figures.