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Video: What Is ABC Inventory Analysis?

What Is 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

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

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.

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 disciplines.
• 1950s: Joseph M. Juran and W. Edwards Deming were founders and proponents of quality management (QM), which relies on ABC analysis. They brought the concept to Japan, which helped create the post-war Japanese Economic Miracle.
• 1960s: Based on quality management concepts, total quality management (TQM) employed the ABC concept and enjoyed widespread popularity during the late 1980s and early ‘90s.
• 1970s: UPC barcoding and scanning came into use in retail in 1974. The Department of Defense implemented a barcode inventory control system in 1981. Barcodes and scanning allowed for much easier tracking of products throughout their life cycle, supporting ABC-based inventory management.
• 1980s: Lean Six Sigma is all about eliminating excess in manufacturing. Using ABC analysis in conjunction with lean approaches started in the ‘80s and continues today.
• 1990s-present: As a central database that has robust inventory information, enterprise resource planning (ERP) systems support ABC inventory analysis and its use in combination with other inventory management methods. Today, ERP systems are used worldwide to assist with classified item inventory management.

NetSuite’s ERP Software Helps Inventory Managers Make the Most of ABC Analysis

To simplify and automate selective control, ERP systems that include ABC analysis has become a standard tool for inventory managers. With ERP, users can execute full ABC analysis based on user-defined criteria, risk analysis and schedule optimization. Learn more about the value of ERP with "Enterprise Resource Planning Systems Transform, Integrate and Scale Businesses".

NetSuite’s ERP software helps businesses maintain optimum supply levels with real-time inventory visibility that helps them avoid overstocks and stockouts. ERP's predictive analytics anticipate demand dips or spikes and alert inventory teams if there’s a change in demand or stock levels. Find out how ERP can streamline mission-critical inventory management processes.