Having good inventory management as an entrepreneur is crucial for business growth. No matter one’s industry, it helps to sustain stock levels and prevent stock shortages. But inventory management can be a challenging task, especially as a newbie retailer.
However, there’s an industry-standard solution at your disposal — running an ABC analysis. This analysis breaks down one’s inventory based on the items that provide the best returns, which allows businesses to manage their inventories more effectively. This article will therefore give a brief overview of what an ABC analysis is, before highlighting how it can be applied to help your business to boost profits.
Table of Contents
What is ABC analysis?
The classifications of ABC inventory analysis
How to calculate an ABC analysis
The benefits of ABC analysis
The steps to run an ABC analysis
The best practices for ABC analysis
ABC analysis in different industries
The bottom line
What is ABC analysis?
ABC inventory analysis refers to a categorization system that organizes and identifies the value of inventory units based on their significance to a business. Risk data, cost, and demand are the key factors ABC analysis uses to categorize and group various key items. As a result, sellers will discover the goods and services that are most valuable to their business.
The classifications of ABC inventory analysis
In ABC analysis, sellers classify their goods and services into a minimum of three groups:
- Group A signifies the most vital stock-keeping unit (SKU) based on sales or volume. Also, this group has the smallest number of items.
- Group B follows A — in terms of importance, however, the items in this group are usually larger in volume with less overall utility than group A.
- Group C is the SKU with the least importance. It contains the largest volume of goods, but those with the least revenue-generating value.
In rare cases, some sellers prefer to group their goods and services into more than three categories.
Regarding the Pareto principle, group A represents the 20% of items that produce 80% of revenue. Group B is at a mid-level representing 30% of goods and services that releases 15% to 20% of the generated income. While the remaining 50% from group C only produces 5% of revenue. As a result, this analysis helps businesses to make informed decisions by focusing on those key SKUs responsible for the most revenue.
How to calculate an ABC analysis
First, it’s important to note that inventory managers can run an ABC analysis calculation for both individual and group inventory stock.
Here are the five necessary steps to run the ABC analysis:
- Multiply every item’s price by the annual quantity of products sold.
- Based on item value, create a group for each product in descending order.
- Next, add the total number of items and their usage value.
- Calculate the cumulative percentage of the consumption value of each item annually, and the percentage of items sold.
- Lastly, split the final data into three groups with a ratio of 80:15:5.
Here’s an example of calculating the ABC analysis in a shirt store — with practical steps to illustrate the process.
Step 1: The first step in ABC analysis is to multiply the cost of each product by the sum of total items in the store.
| Items | Total number of items sold (annually) | Cost per good | Usage value (annually) |
| Denim Shirts | 7,500 | $100 | $750,000 |
| Corporate shirts | 10,000 | $250 | $2,500,000 |
| T-shirts | 20,000 | $25 | $500,000 |
| Polo shirts | 5,000 | $30 | $150,000 |
Step 2: Next, arrange the number values in descending order.
| Items | Total number of items sold (annually) | Cost per good | Usage value (annually) |
| Corporate shirts | 10,000 | $250 | $2,500,000 |
| Denim Shirts | 7,500 | $100 | $750,000 |
| T-shirts | 20,000 | $25 | $500,000 |
| Polo shirts | 5,000 | $30 | $150,000 |
Step 3: Do a sum of the annual usage value and quantity of goods sold.
| Items | Total number of items sold (annually) | Cost per good | Usage value (annually) |
| Corporate shirts | 10,000 | $250 | $2,500,000 |
| Denim Shirts | 7,500 | $100 | $750,000 |
| T-shirts | 20,000 | $25 | $500,000 |
| Polo shirts | 5,000 | $30 | $150,000 |
| Total | 42,500 | $3,900,000 |
Step 4: Get the percentage of the annual number of each item sold and its usage value.
| Items | Total number of items sold (annually) | Cost per good | Usage value (annually) | % of items sold (annually) | % of Usage value (annually) |
| Corporate shirts | 10,000 | $250 | $2,500,000 | 23.52 | 64.1 |
| Denim Shirts | 7,500 | $100 | $750,000 | 17.65 | 19.23 |
| T-shirts | 20,000 | $25 | $500,000 | 47.05 | 12.82 |
| Polo shirts | 5,000 | $30 | $150,000 | 11.76 | 3.84 |
| Sum Total | 42,500 | $3,900,000 |
Step 5: Finally, group the data into category A, B, and C.
| Ratio | Items | Total number of items sold (annually) | Cost per good | Usage value (annually) | % of items sold (annually) | % of Usage value (annually) |
| 83.33% ( A) | Corporate shirts | 10,000 | $250 | $2,500,000 | 23.52 | 64.1 |
| Denim Shirts | 7,500 | $100 | $750,000 | 17.65 | 19.23 | |
| 12.82 (B) | T-shirts | 20,000 | $25 | $500,000 | 47.05 | 12.82 |
| 3.84 (C) | Polo shirts | 5,000 | $30 | $150,000 | 11.76 | 3.84 |
| Sum Total | 42,500 | $3,900,000 |
The benefits of ABC analysis
There are several benefits of using ABC analysis that make it an important tool to use for optimizing inventory management and improving overall performance.
Inventory optimization
With ABC analysis, sellers can identify which products are in high demand. As a result, store managers can stock up more of the high-demand goods in the warehouse and reduce the stock of products in categories B and C. This allows them to sustain the working capital turnover ratio and improve business security.
Up-to-the-minute supplier concessions
Because companies make 70 to 80 percent of their sales from group A products, it’s normal to negotiate better deals with suppliers for those specific goods. If lower costs don’t work with the manufacturers or suppliers, sellers can negotiate for free shipping. Alternatively, sellers can request a down payment reduction or a post-purchase agreement to cut their initial purchase price.
Improved product life cycle and enhanced inventory projection
ABC analysis helps businesses get a clear understanding of the current life cycle of a product and make accurate predictions of the item’s future demand. As a result, businesses can have an almost perfect stock inventory level. Also, managers can have a more detailed sales projection — which means companies can set more accurate price levels.
Streamlined supply chain organization
Sellers can leverage ABC analysis to know the perfect time to use a single supplier source to simplify their operations and cut costs. Alternatively, they can look at the analysis results and confirm if they need to combine multiple suppliers to increase sales.
For instance, with category C having only one supplier, the operation process is easy because the manager saves the time of sourcing from various suppliers to do other crucial tasks.
On the other hand, managers can use the category A data to get a range of suppliers, so in the event that one supplier isn’t delivering, another supplier can be called in as a substitute. That way, the supply process becomes more secure.
The steps to run an ABC analysis
Identify what needs to be analyzed and predict the success quotient
Two critical objectives will likely drive a business to do an ABC analysis. First, to reduce the purchasing cost. Second, to boost the profit margin by considering and storing the most valued goods in a warehouse.
Collect data needed for analysis
The next key step is to collect the annual purchase data for every single stock item — such as the transportation costs, production, weighted gross, and order cost, amongst others.
Outline the inventory in descending order
Here, sellers arrange the various stock items and value them in descending order — starting from the most productive to the least.
Estimate the cumulative impact
This step involves managers making a list of their products and inputting them into a spreadsheet. With this, it’s easier to calculate the cumulative effect on the business. Managers can start by dividing the products into two columns.
The first column is the sum of the products sold, while the second is for the products’ annual costs. Then, managers can classify the inventory by working out the cumulative percentage of the annual usage value.
Arrange the inventory based on the highest demand
In this step, businesses need to use the Pareto Principle. It’s not always necessary for managers to apply the 80/20 rule, but they have to use a similar way to rank the products. For instance, managers can include steps like confirming the product’s optimal value, framing the product price strategy, beneficial negotiation with the suppliers, and so on.
Observe the classifications and rank the products accordingly
Finally, businesses have to carefully analyze the classifications and organize the products based on their revenue generation. So, if a specific item has low returns, it will be placed at the bottom of the list, while the higher return products will stay at the top. Also, businesses have to monitor product performance, pricing, and customer demand.
The best practices for ABC analysis
Keep categorizations simple
One of the best practices of ABC analysis is to classify items in a way that’s easy to sort. Managers can classify items based on how often they move through the company. They can also create an “out of stock” category for fast-moving products and classify the items based on their gross profit margin.
Another practical approach is to categorize items into classes A, B, and C. Class A will have expensive products, Class B will have moderately-priced products, and Class C will consist of the least expensive items.
Allot service and labor levels simultaneously
Businesses have to allocate service levels based on the product’s class. For example, they can spend 5 hours reviewing 50 Class A items that are more expensive, and 5 hours reviewing 5,000 Class C items that are less expensive.
Brands can also consider scheduled cycle counting based on product classification. That way, one can focus on more regular cycle counting on Class A products whilst reducing time spent on other classes.
Section the KPIs by class
Managers must create definite dashboards, KPIs, and consistent reports for each class to understand the performance and strength of the business.
Create performance reviews
When the full inventory maintenance is due, managers can carry out performance reviews based on the ABC classifications. It will help the business have fewer delays and reduce operating costs as products reach consumers quickly to increase revenue.
Evaluate surplus stock
Some businesses don’t have surplus stock because it may be unnecessary and risky to hold. But if the surplus stock seems justifiable based on the analysis, businesses can classify this inventory properly.
Also, for a more organized approach, some successful businesses use the just-in-time management system to help them get goods at the exact time they are required. That way, they avoid stocking them long before required.
Run across locations
Supply chain managers need to oversee physical locations because it increases customer satisfaction by moving goods through the supply chain cost-effectively while also ensuring reliability.
Always count inventory in transit
Typically, items move between locations. Hence, managers must keep track of these items by monitoring the period between the shipment and receipt date. That way, it’s possible to keep inventory records in order. Additionally, businesses need to register losses and damages.
Product reclassification should be flexible
Flexibility is key when reclassifying products. For instance, managers may do a periodic inventory reclassification due to consumers’ buying habits, a change in KPIs, or a rise in the popularity of new products.
Consider inventory and sales in the cycle
Managers have to acknowledge the relationship between inventory and sales. When there’s a sales surge, inventory increases, and businesses have to restock against their assumed schedule. Contrarily, when sales decline, inventory decreases, and a re-examination of product classes and stock levels should occur.
Leverage technology and insights from data
Automated systems help businesses complete tasks in a short time, for example by knowing upticks in demand, completing replenishment processes, and so on. With this data, managers can easily supervise demand planning and lead times.
ABC analysis in different industries
ABC analysis in retail and e-commerce
ABC management is beneficial for the e-commerce and retail industry, especially in terms of customer segmentation. Retailers can utilize the data from ABC analysis to know their most successful products, and as a result, they can emphasize the promotion of such products through advertising — which can boost overall sales.
Warehousing
ABC inventory classification is vital for warehouses because it helps with stock cycles. For example, managers can use the inventory classification to count class A items quarterly. Class B products could require bi-annual counting, while class C items can be counted annually.
ABC analysis in manufacturing industry
With ABC analysis, manufacturers are able to find out the margin and products required to keep the top 20 percent of goods growing. Hence, they can use the data to prioritize human resources, time, and financial resources.
ABC analysis in automobile industry
Thanks to ABC analysis, manufacturers in the automotive industry can:
- Monitor the value of their line workers
- Identify the most durable equipment
- Get the data needed to fine-tune production and boost profits
Because the manufacturer has inventory control, such insights can help understand the correct supply levels, in turn allowing manufacturers to negotiate better deals with suppliers and optimize their production.
The bottom line
These days, many businesses implement ABC analysis as a data-driven approach to improve accuracy, accountability, and innovation. With this procedure, inventory managers can categorize stocks based on revenue generation and value. It also allows businesses to plan their expenditure properly.
There’s a reason why ABC analysis has become an industry favorite, and this guide has therefore aimed to highlight how it can help you to manage your inventory effectively, and in turn, focus on the products that can boost your overall revenues.
