ABC Analysis in Inventory Management?

ABC analysis is an inventory management technique that determines the

value of inventory items based on their importance to the business. ABC
ranks items on demand, cost and risk data, and inventory mangers group
items into classes based on those criteria. This helps business leaders
understand which products or services are most critical to the financial
success of their organization.

The most important stock keeping units (SKUs), based on either sales volume
or profitability, are “Class A” items, the next-most important are Class B and
the least important are Class C. Some companies may choose a classification
system that breaks products into more than just those three groups (A-F, for
example).

ABC analysis in cost accounting, or activity-based costing, is loosely related

but different from ABC analysis for inventory management. Accountants use
activity-based costing in manufacturing to assign indirect or overhead costs
like utilities or salaries to products and services.

How ABC Analysis Relates to the Pareto Principle

The Pareto Principle says that most results come from only 20% of efforts or
causes in any system. Based on Pareto’s 80/20 rule, ABC analysis identifies
the 20% of goods that deliver about 80% of the value.

Therefore, most businesses have a small number of “A” items, a slightly larger
group of B products and a big group of C goods, a category that that defines
the majority of items.

Classes in ABC Inventory Management

 Annual
Percentage of Total Consumption
Type Importance Inventory Value Controls R

Class A High dollar value 10% – 20% 70% – 80% Tight High

Class B Medium dollar value 30% 15% – 20% Medium Good

Class C Low dollar value 50% 5% Basic Mini

The Pareto Principle may not always be completely accurate. However,

analysis shows that valuable things do tend to bend toward an 80/20
distribution. ABC analysis identifies the “sweet spot” where most of a
business’s revenue comes from with relatively little effort.

How Is ABC Inventory Analysis Calculated?

Conduct ABC inventory analysis by multiplying the annual sales of a certain
item by its cost. The results tell you which goods are high priority and which
yield a low profit, so you know where to focus human and capital resources.

Use this formula for ABC inventory analysis:

(Annual number of items sold) x (Cost per item) = (Annual usage value per
product)

You can use Microsoft Excel to do a basic ABC inventory analysis. List each
product or resource in descending order according to its product usage value.
Calculate the total of each item in the aggregate amount. Determine the
values for the A, B and C categories, then assign a group name to each item.
The goods with the highest value then get the manager's closest attention.
 Example of an ABC Analysis Calculation
Below is an example of an ABC analysis of inventory for a small retail
business that shows the Pareto Principle at work, with many lower volume
products also among the highest-value ones. The resulting Pareto Diagram
shows the characteristic curve that illustrates the 80/20 rule, where items rank
and roughly where to drop them into A, B or C classifications.

For more information about benefits and best practices, check out our
inventory management guide.

How ABC Analysis Simplifies Work for Inventory Managers

Inventory managers are always looking for ways to improve pricing and quality
or to achieve greater efficiencies. In light of that goal, they may use the ABC
technique, sometimes called the “always better control” method. They can use
the analysis to focus their time and effort primarily on Class A inventory and
less on B and C class products. For example, inventory managers will use
ABC analysis to check the purchase orders of the highest value (Class A
items) products first, since these generate the most revenue.

Why Use ABC Analysis?

Using ABC analysis for inventory helps better control working capital costs.
The information gained from the analysis reduces obsolete inventory and can
boost the inventory turnover rate, or how often a business has to replace
items after selling through them.

ABC Analysis Benefits

A long list of benefits can result from applying ABC analysis to inventory
management, including:

 Increased Inventory Optimization: The analysis identifies the products that

are in demand. A company can then use its precious warehouse space to
adequately stock those goods and maintain lower stock levels for Class B or
C items.
 Improved Inventory Forecasting: Monitoring and collecting data about
products that have high customer demand can increase the accuracy of sales
forecasting. Managers can use this information to set inventory levels and
prices to increase overall revenue for the company.
 Better Pricing: A surge in sales for a specific item implies demand is
increasing and a price increase may be reasonable, which improves
profitability.
 Informed Supplier Negotiations: Since companies earn 70% to 80% of their
revenue on Class A items, it makes sense to negotiate better terms with
suppliers for those items. If the supplier will not agree to lower costs, try
negotiating post-purchase services, down payment reductions, free shipping
or other cost savings.
 Strategic Resource Allocation: ABC analysis is a way to continuously
evaluate resource allocation to ensure that Class A items align with customer
demand. When demand lowers, reclassify the item to make better use of
personnel, time and space for the new Class A products.
 Better Customer Service: Service levels depend on many factors, like
quantity sold, item cost and profit margins. Once you determine the most
profitable items, offer higher service levels for those items.
 Better Product Life Cycle Management: Insights into where a product is in
its life cycle (launch, growth, maturity or decline) are critical for forecasting
demand and stocking inventory levels appropriately.
 Control Over High-Cost Items: Class A inventory is closely tied to a
company’s success. Prioritize monitoring demand and maintaining healthy
stock levels, so there’s always enough of the key products on hand.
 Sensible Stock Turnover Rate: Maintain the stock turnover rate at
appropriate levels through methodical inventory control and data capture.
 Reduced Storage Expenses: By carrying the correct proportion of stock
based on A, B or C classes, you can reduce the inventory carrying costs that
come with holding excess inventory.
 Simplified Supply Chain Management: Use an ABC analysis of inventory
data to determine if it’s time to consolidate suppliers or shift to a single source
to reduce carrying costs and simplify operations.

ABC Analysis Limitations

 ABC analysis, despite all its benefits for inventory maintenance and
management, is not a one-size-fits-all inventory management solution. Every
organization has specific customer demand patterns, classifications, systems
and other issues that affect the usefulness of an ABC analysis.

The disadvantages of ABC analysis stem from two issues: an emphasis on

the dollar value of inventory and the significant amount of time and discipline it
takes to apply the method. Here are a few more challenges:

 Parameter Instability: ABC analysis often results in managers assigning up

to 50% of items to a new category every quarter or year. Often, companies
are not aware of the changes until there is a problem with demand, and the
need to reassess may take up valuable time and jeopardize customer
satisfaction.
 Limited Pattern Consideration: The standard ABC method will not account
for factors like new product introductions or product seasonality. For example,
a new product may have low sales volume because it has no buying history.
ABC analysis has a somewhat static perspective on demand and will generate
inventory inefficiencies whenever demand is shifting or unclear.
 Low Information Extraction: ABC class information may not provide all the
statistical data or detail needed to make informed, strategic management
decisions.
 High Resource Consumption: Giving disproportionate weight to trivial
issues is known as bikeshedding, which can be an unfortunate consequence
of ABC analysis. Since ABC analysis is easy to grasp, staff may inject their
opinions or request their own variants making ABC analysis a resource-
consuming process rather than a time-saving tool.
 Value Blindness: ABC analysis ascribes product importance based on
revenue or frequency of use, but some items may not hold to this paradigm.
For example, a retail display item may rarely sell but may attract a lot of
customers (who will buy other products) based on its novelty. In aerospace, a
specific part for a plane may not be used often and have little market value,
but it may be a fundamental safety function.
 System Incompatibility: ABC inventory analysis conflicts with traditional
costing systems and is out of compliance with generally accepted accounting
principles (GAAP) requirements. If you must run multiple costing systems,
labor costs will rise alongside inefficiency.
 Undersupply or Oversupply Issues: One ABC analysis disadvantage is it
looks at dollar-based values, rather than the volume that cycles through
 inventory, so there is a risk of running out of Class B or C items. The opposite
can occur, too. You may have excess low-class items that accumulate in
inventory if you reorder them without regular reviews.
 Loss Risk: Just because B and C items do not have as high a value as Class
A products does not mean they no value. One of the limitations of ABC
analysis is that excess stocks are always in jeopardy of obsolescence or
damage. Therefore, the inventory that habitually goes uncounted or
unmonitored may be subject to theft.
 Mandatory Standardization: The ABC method is only successful if every
item is subject to the standardization of materials, which includes how they
are named, stored, and consistently rated and monitored.
 Arbitrary Categorization: Without preset boundaries or agreed-upon
standards for each category, classifying goods depends on the manager's
professional judgment. So this can be a relatively subjective process.
 Business Limitations: ABC analysis is not useful for companies that have an
equable annual consumption value of inventory items by type. For instance, a
company that sells the same version of an item like candy, nails or socks, may
not be able to sort stock based on the Pareto Principle.
 High Resource Consumption: Companies with a significant number of
inventory items will have to hire additional staff or buy special equipment to
control inventory using ABC categorization.

How to Perform ABC Analysis

A thorough ABC analysis begins with identifying the objective you’re trying to
reach. Once you have that, collect the necessary information to categorize the
items. Once the classes are in place, closely track and make decisions based
on the resulting data.

Here’s how to perform an ABC analysis step-by-step:

1. Identify the Objective: An ABC analysis can help you meet one of two
targets: lower procurement costs or raise cash flow by optimizing
inventory levels of the right items based on customer sales or
production.
 2. Collect Data: The most common data to collect is the annual spend on
each item. This data is in raw purchase dollars. If it’s easy to calculate,
you can gather the weighted cost, including gross profit margin, ordering
and carrying cost data.
3. Sort by Decreasing Order of Impact: Use the ABC analysis formula to
rank each inventory item’s order by cost — from highest to lowest
impact.
4. Calculate the Sales Impact: For each inventory item, calculate its
impact on sales as a percentage by dividing the annual item cost by the
aggregated total of all items spent. This number is the percent, or
fraction, that you will use to compare items in the list. Here’s the
formula:

% Impact = (annual item cost) / (aggregated total of all items

spent) x 100

5. Sort Items into Buy Classes: Once you define the classes, work on
contract renegotiation, vendor consolidation, shifting strategic sourcing
methodology or implementing e-procurement. Making changes in these
areas can provide significant savings or ensure the in-stock availability
of Class A items. Take a holistic view rather than being strict about the
80/20 rule.
6. Analyze Classes: Once categories and strategic cost management are
defined, schedule reviews to monitor the success or failure of decisions.

ABC Analysis Best Practices

ABC analysis best practices stress consistency, sales and attention to events
that may affect stock levels or value. Using technology to manage inventory is
a best practice that simplifies the process from end-to-end.

Apply these best practices when doing an ABC analysis:

 Keep Classifications Simple: Categorize items based on how frequently
they move through your organization. Fast-moving items are more subject to
stockouts. You can also categorize items based on value or gross profit
margin. The most expensive items would be placed in Class A, average price
items in Class B and the least expensive in Class C.
 Assign Service and Labor Levels at the Same Time: Assign service levels
based on an item’s class. The Class A goods have the highest targets, while
the last class products have the lowest ones. For instance, managers would
spend 10 hours reviewing 100 Class A items and 10 hours reviewing 10,000
Class C items. Schedule cycle counting by classification, ensuring more
regular cycle counting is performed on Class A items (those which make the
biggest and most significant impact on sales performance) more regularly
than Class B and C items.
 Segment KPIs by Class: Create distinct KPIs, corresponding reports and
dashboards for each class.
 Establish Performance Reviews: Conduct performance reviews when doing
full inventory maintenance or around schedules and rules that depend on ABC
classifications.
 Review Surplus Stock: Decide if your current surplus stock levels make
sense for your company. In the global, just-in-time economy, the surplus stock
may pose unnecessary risk and holding costs. If it makes sense to hold onto
this inventory, classify it correctly.
 Manage Across Locations: Supply chain managers need the ability to
manage inventory across physical locations.
 Count Inventory in Transit: When stocks move between locations, track the
time between shipment date and receipt date. Audits like these keep inventory
records in order and ensure you register damage or loss.
 Reclassify Purposefully: Remain flexible in how and when you reclassify
items. You may need to reclassify inventory periodically because of market
changes, alterations in your customer base or their buying habits, new
products that become popular, or a shift in your KPIs or business strategy.
 Consider Sales and Inventory in Tandem: Recognize the relationship
between sales and inventory. As sales increase, inventory turn increases, and
you’ll need to restock against an assumed schedule. Conversely, a downturn
in the marketplace may call for a re-examination of item classes and stock
levels. Review pricing as well as promotional strategies based on
classification.
 Leverage Technology and Resulting Data: Inventory managers use
automated systems to complete replenishment processes, recognize upticks
in demand and avoid fulfillment problems. Use data to manage lead times and
demand planning.

Using ABC Analysis for Cycle Counting

Cycle counts are a scaled-down version of physical inventory counts at set
times during the business year. ABC analysis ensures more frequent counts
of crucial, high-volume items.

Cycle counting provides a system of checks and balances to ensure the

inventory records in the inventory management system are accurate. Regular
cycle counting can be scheduled by classification, ensuring more regular cycle
counting is performed on Class A items — those which make the biggest and
most significant impact on sales performance — than Class B and C items.

How to Implement ABC Inventory

Management
The best way to implement ABC inventory management is to first assess
whether it would be effective for your business. Avoid assumptions by asking
critical questions. Once you decide to move forward, make any necessary
preparations for a smoother execution.

Use this questionnaire to assess your readiness for ABC analysis

implementation. If you answer “No” to any questions, you need to do more
preparation before completing an ABC analysis:

ABC Inventory Implementation Questionnaire

Issue Query Yes

Information Is by-item demand and cost information reliable and

 Issue Query Yes

Gathering accessible?

Systems Are processes and systems in place for the effective operation
Considerations of the ABC analysis method?

Business Case Have the benefits of implementing and operating been

quantified using specific, measurable, achievable, relevant,
and time-bound (SMART) targets and goals? Do the benefits
outweigh the risks?

Change Impacts Have you assessed the effects of a move to ABC analysis?

Timing Have you established a realistic implementation timeline?

KPIs Have you determined the KPIs to track to measure cost

savings?

Applying ABC Analysis and Calculations

Use Cases in Various Industries
Almost every type of business can benefit from ABC analysis. Companies
worldwide use the method to improve processes and increase profitability.

So how can businesses in various industries employ the 80/20 ratio and ABC
analysis?

 Retail: Retailers use ABC analysis identify the products most profitable to the
business. They can then use the data to promote those products across retail
locations and ensure there is adequate stock on hand.
 Automotive: The ABC method enables automotive manufacturers to analyze
the effectiveness of line workers, obtain details that inform resource utilization,
and determine what equipment is the highest-performing. Inventory control
 also provides insight into the necessary raw materials and valuable
information to negotiate new or better contracts with suppliers.
 Warehousing: In the warehouse, ABC analysis and segmentation allow the
inventory controller to focus on ways to better manage higher value inventory,
including the correct amount of safety stock to avoid stockouts. Data can also
prompt rethinking products sold and sunsetting goods.
 Manufacturing: In a manufacturing setting, ABC analysis helps increase
profit margins by classifying the top 20% of products by revenue.
Manufacturers can use the analysis to determine the most parts and materials
those products require and margins. They can use these findings to prioritize
people, time and materials to make the greatest impact.

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History of ABC Analysis

The foundation of ABC analysis stretches back to the early 1900s, when
inventor Vilfredo Pareto discovered the law of the vital few and applied it to
economics. Today, ABC is a pillar of inventory management.

 1900s: Economist Vilfredo Pareto discovered the 80/20 rule that states

income follows distribution in inverse proportions. Since he discovered the
principle in 1906 and noted its applications to economics, industry, science
and sociology, it has been used worldwide in a variety of disci