If you have read or done research on inventory management, you might’ve heard the term “ABC Analysis”. Or you have not heard of it at all but you want to optimize the inventory in your warehouse. Either way, this will be a great tool to have if you’re one of the above.
What is ABC Analysis?
So, what is ABC Analysis?
In inventory management, ABC Analysis a technique used to categorize products. ABC Analysis provides you with the mechanism to identify items that could affect your overall inventory cost – specifically, your storage cost. Once you start using this tool, it helps you to determine specific controls and management policy for each item or product. And it does that by dividing the items into three categories which will be discussed below.
The primary purpose of ABC analysis is to optimize the inventory in your warehouse. Inventory optimization is extremely important if you want to lower the cost of the supply chain.
How is this possible?
Thanks to the Pareto Principle. Now, you might ask “What is Pareto Principle?”
The Pareto principle is a management technique that could assist decision making. It is used in many fields, including inventory management. The Pareto Principle is also known as the 80/20 principle. Basically, Pareto Principle states that 20% of the product in your inventory will generate 80% of revenue.
According to Pareto Principle, 80% of the total customer purchased is derived from only the top 20% of products. Therefore, it could be said that demand is not evenly distributed among products; On the contrary, top products generally outperform the rest of the offering.
What are the three categories?
Based on Pareto Principle, the ABC analysis divides a business’ inventory into three categories. Which are, as mentioned before, A, B and C. ABC analysis suggests that inventories of business are not of equal value. Therefore, it is divided into three categories based on its importance.
Below is the description of each categories in ABC Analysis:
- A-Items are product with the highest annual consumption value. A-Items accounts for between 70-80% of a company’s revenue. Usually, only 10-20% of items in your inventory could be categorized as A-Items.
- B-Items are also commonly known as interclass items. B-Items are items with a medium consumption value. B-Items are made of 20%-30% of items in your inventory, while generating between 10-15% of the company’s revenue. This interclass items could quickly become an A-Items or C-Items.
- C-items, as you might expect, are items with the lowest value. It only contributes to 5-10% of your annual revenue. C-Items accounts for between 60-80% of your whole inventory.
With this categorization in mind, you could easily identify the stocks that are frequently moving. Then you can separate them from other items, especially from items that are numerous but are not profitable.
Example of ABC Analysis
The graph above shows the yearly sales distribution of an online retailer. In this example, there are 17,000 products that are being analyzed. The products in this graph are ranked based on the most sold volume.
How do we interpret this chart?
The horizontal scale represents the item in your inventory, while the vertical scale represents the total amount of revenue generated by the item.
As you can see, the first 2,500 products are generating 70% of the revenue. Therefore, product 1 to product 2,500 are classified as Items A. As we discussed earlier Items A are 10-20% of items in your inventory that could generate up to 80% of your revenue. In this case, 70% of the revenue were generated from 15% of items.
After determining items that are categorized as Item A, we could now categorize item in the Items B category.
Items B category are made of 20-30% of items in your inventory. In the chart above, we could see that Item 2,501-6,500 contributes to 20% of the business’ revenue with 25% of the business’ inventory. Therefore, we could categorize Item 2,501-6,500 as Items B.
Finally, we could now categorize Items C.
After Items B (Green Box), the graph started to flatten until the end. This means that Item 6,501 to 17,000, which made 60% of the total inventory that the business has, only generates 10% of the total revenue. Based on the Pareto Principle, we could now categorize Item 6,501 to 17,000 as Items C.
Now, we can drive 3 conclusions based on the chart above.
- Items A generates 70% of the revenue with only 15% of items in the inventory
- Items B generates 20% of the revenue with 25% of items in the inventory
- Items C generates 10% of the revenue with 60% if items in the inventory
This example is quite similar to text-book Pareto situation.
Now, since you already understand how to interpret the chart and the categories of ABC Analysis, we could move on to the next topic.
How does ABC Analysis could help my business?
The next question that you might ask is “How can it help me?”, right?
With the ABC Analysis, we can start to create simple Inventory Policy. And that’s by applying a unique and appropriate inventory management policy for each category.
By making policies based on ABC Analysis, you could balance the sales imbalance that is outlined by the Pareto Principle. Therefore, each item category should be treated based on its importance, sales, and demand. Below is an example of inventory management policy that is based from our ABC analysis earlier.
- Items in category A or A-Items will have strict inventory control. A-Items should have dedicated/reserved storage area. Frequent reorders of items in this category is recommended to prevent stock shortage. Since this item is fast-moving item which contributes to 70-80% of the revenue.
- While B-Items is not as important as A-Items, it should be monitored closely as well. Items in this category could evolve into both A-Items and C-Items. Therefore, it is important not to overlook items in this category. Restocking B-Items should not be as frequent as A-Items, since it only contributes to 10-20% of the revenue, and its demand is not as high as A-Items.
- C-Items are the least important category, since it only contributes to less than 10% of the revenue. Items in this category have the lowest demand compared to the other two categories. It is ideal if there are only 1-2 stock per item in this category. This policy will cause items in this category to be sold-out after each sale, and restocking/reordering should only be done if the item is out of stock. Therefore, this could decrease your inventory cost significantly by reducing the amount of product that couldn’t be sold quickly in your inventory.
By creating specific policy for each category, you could ensure that your best-selling items are never out of stock. At the same time, it also ensures items that have low demand will not cause excessive inventory cost. However, you should perform an ABC Analysis periodically since customer demand could change from time-to-time.
In the end, ABC Analysis is simply a technique that could greatly benefits your business by customizing each item stock-keeping policy based on their contribution to revenue.
Now, I know that I’m not a psychic but some of you might wonder how to do an ABC Analysis easily, right?
We got you covered.
Simply head over to this link and we’ll give you a free ABC Analysis template for Microsoft Excel. You don’t need to be an Excel nerd to use it since instructions are provided in the file, and the interface is pretty self-explanatory by itself.
Thanks for visiting, and that’s it for now!