What Is ABC Analysis?
Businesses employ a variety of techniques for Inventory Management. However, there is no one-size-fits-all system, so you need to identify which technique (or combination of techniques) works for your business. One of the most popular and rather efficient methods that many businesses use is ABC Analysis.
ABC Analysis is a method of classifying a company’s products or inventory into three different types, depending on movement or activity. It is a derivation of the Pareto Principle that was conceptualized by Vilfredo Pareto, a renowned Italian economist. This principle states that 80% of any total output comes from just 20% of the contributing elements. It is a principle that can be applied to different aspects of the business but is most commonly used in inventory management.
Classify Products as A, B, or C
In ABC analysis, a company’s inventory is segregated into types A, B and C using the criteria suggested by the Pareto Principle.
Type A Inventory
Inventory that is high-volume or high-value and make up 80% of the company’s total sales fall under type A. This typically includes a company’s most popular products or bestsellers. The total quantity of type A inventory in any business usually makes up only about 20% of the company’s entire product portfolio.
Type B Inventory
Average-volume or average-value inventory is classified as type B. There are more of these SKUs than the top-selling products in type A, often making up approximately 30% of the company’s total inventory. They contribute to about 15% of the total revenue. Products that fall into this category may be promoted to type A if the product sales improve.
Type B Products may be reclassified to either A or C if sales either increase or decrease. Remember, all these product classifications may change over time as demand for portfolio either grows or wanes.
Type C Inventory
Finally, inventory that are low-volume or low-value and make up only 5% of the company’s revenue fall under type C. This is the biggest group of products, comprising half of the company’s total inventory. These are also the items that are not very much in demand but are still included in the company’s product list. It is not considered a high priority to keep these items in stock at all times as they do not contribute significantly to the company’s total revenue.
What Are the Benefits of ABC Analysis?
There are a number of Business Advantages you can enjoy by using ABC analysis for the different aspects of your business. Here are some of the most notable benefits.
1. Efficient Inventory Management
Focus On Fast-Moving SKUs
By using the categorization technique of ABC analysis, a company’s purchasing or inventory manager can easily identify which products are fast-moving and generate the most sales. They can then focus on these items which are, after all, responsible for majority of the company’s revenue. Close monitoring of type A products is crucial so that adequate supply can be maintained at all times.
Reduce Inventory of Slow-Moving Stock
Likewise, the inventory manager will know which products do not have much activity. The company does not need to maintain abundant stocks of these items as they will just take up space and use up resources that could be better allotted for the faster-moving items.
2. Increased Time Efficiency
Going through a company’s inventory list can be a meticulous and time-consuming process, particularly if the list contains hundreds or thousands of items. With the help of ABC analysis techniques, an inventory manager will not need to go through every single item in the company’s brochure.
If they are pressed for time, as businesses usually are, all they really have to check are the A products since these are the ones that make the largest contribution to the company’s revenue. SKUs in the C category usually don’t make much of a dent to the overall sales and it’s not considered wise to spend several hours on checking their inventory, especially if you have time constraints.
3. Better End of Life Management
There are generally four broad phases that products go through in any business:
The maturity phase is where the product has the highest market demand but it is also the turning point that will eventually lead to the decline and possible discontinuation of the SKU.
When ABC analysis is used, an inventory planner will be easily able to identify the current cycle of any product. They can gradually reduce inventory for products that are at the end of their maturity phase as these items will most likely soon experience an inevitable decline in demand.
4. Strategic Pricing
Using the categorization methods of ABC analysis, it is easy to see which products bring more value by generating more sales for your business. With the knowledge that these items are more in demand, you can increase their prices so that these high-demand products may generate more revenue for your company.
5. Better Supplier Negotiations
Once you have classified your products into types A, B and C, it will be clear to see which items you should prioritize on acquiring at the lowest possible investment. Thus, you can start practicing better and more persuasive negotiation tactics with the suppliers of these products to reduce the buying cost, and to consequently maximize your sales.
Is ABC Analysis Suitable for You?
As with all other business techniques and methodologies, ABC analysis is not the perfect solution for every single company’s inventory challenges. There are businesses that can benefit greatly from the application of ABC analysis while there are also others that may not see that much of a difference.
Specifically, companies that have a very long list of products would find it highly valuable to train their inventory personnel in ABC analysis. The more products you have, the more complicated and tedious the inventory procedures can become. ABC analysis drastically cuts down the time and other resources used for inventory management.
It is important to understand, however, that for ABC analysis to be effective, you should have an organized system in place for monitoring and tracking all your product orders and sales.
Example: Sporting Goods Retailer
Let’s say you own a local sporting goods store. You carry all kinds of sporting gear and accessories, each with different levels of demand. You want to improve your cash flow and maximize your revenue so you use the ABC analysis method to classify your inventory according to generated sales.
After going through your product list, you find out that bikes currently have a very high demand so you put this inventory in the A group, together with yoga mats, jumping ropes and other home workout accessories that also have high sales. You want to make sure that you always have a good stock of these items so that you don’t run out.
In contrast, you see that golfing attire has not been selling well. In fact, there are simply not golf courses near your store, and you don’t anticipate selling much golf apparel in the near future. For this reason, you classify golf apparel as Type C. You still want to keep a limited quantity in stock but are not very concerned if you run out, since they are currently not contributing that much to your revenue.
By doing this analysis, you are ensuring you have adequate supply of the products with the most demand from your customers, while not tying up shelf space for inventory that doesn’t sell.
Wrapping It Up
ABC Analysis is an elegant inventory management technique practiced across many industries. By giving clarity to the most valuable inventory, it allows your supply chain personnel to focus on the products that have the most impact on your business.