Inventory Management: What is ABC analysis and When do you need it?

If you have been searching for the best technique to manage your inventory with hundreds or thousands of different items, we have got the answer: ABC Analysis (also known as ABC Classification).

What is an ABC Analysis?

The ABC analysis is a ranked categorization technique based on the Pareto Principle (a business metric that proposes that 20% of the inputs determine 80% of the outcomes). It is intended to concentrate efforts and resources to the company’s priority items and minimize the number of operational tasks and overhead costs associated with inventory management. Historically, the ABC analysis arose from a materials management perspective. Its usage helps the inventory management teams to identify the most critical products on their portfolio and group them in terms of how useful they are for achieving business goals considering their estimated importance. Since the 2000s, this technique has been used primarily as a data visualization method, and a way to prioritize the focus of supply chain operators, who have to review the item replenishment policy and parameters within their inventory management system, such as minimum/maximum, economic order quantities values or service levels among other data continuously. The ABC analysis suggests that the items are not of equal value; therefore, they should be grouped into categories or zones. Within the inventory, the classification of each category is made by considering the value of each item. The value is determined by pre-established criteria such as unit cost, annual consumption, or annual monetary volume. Thus, this technique highlights the minority of essential items over the majority of trivial ones. Each category can be handled differently and can have its own specific set of processes, with more attention being devoted to higher-rated groups.

The ABC Categories, Types or Zones

As previously indicated, it is important to divide your inventory into categories, and the conventional labels based on their ratings are: Category A – extremely significant: This is the smallest category and consists of the most important and valuable stock items, which require very tight controls and high accurate record. These belong in this category because of their high cost, level of utilization or significant contribution to profits. It usually represents 12 to 18% of all units, although its value generally ranges from 65 to 75% of the total inventory value. They receive more attention than physical inventories in other areas of the company, such as better negotiations for constant supply, more accurate demand forecasts, frequent reviews, nearby locations, better storage conditions, among other tasks. Category B – moderately important: This category is slightly larger in terms of volume of items. It will usually consist of products of intermediate value with secondary importance, and therefore requires fewer controls and accuracy of records. They generally represent between 20 to 30% of the items, and their value is between 15 to 25% of the total stock valuation. These don’t have the same conditions as the Zone A inventory; however, their shortages still need to be controlled. Category C – marginally relevant: This will typically be the largest category where products represent the majority of inventory volume but are the lowest-value items and will contribute the least to your business goals. They require low supervision and have the least controls possible with minimal records. Category D – relatively unimportant: This category is optional and could be used to include obsolete or unusable items. It can also be used to include items that have not been sold or moved for extensive periods or other internal parameters specified by the business. There are no fixed thresholds for each category. In such case, different proportions can be used based on objectives and criteria; however, the following values are generally applicable:

• Category “A” approximately 20% of items or 70% of the annual consumption,
• Category “B” approximately 30% of items or 25% of the annual consumption,
• Category “C” approximately 50% of items or 5% of the annual consumption.

ABC Classification Criteria

You can segment each product based on certain criteria. The most commonly used are:

• Classification by unit price,
• Classification by total annual consumption,
• Classification by total value,
• Classification by usage and value,
• Classification by contribution to profits.

Performing an ABC Analysis

To compute the categories, the supply chain practitioners need to choose a series of parameters that characterize the ABC analysis:

• the number of categories (usually three),
• the measurement unit used to “weight” the items,
• the historical depth of the measurement,
• the percentage threshold used for each category.

The percentages are associated with the chosen unit to measure the weight over the historical depth. Those percentages are typically associated with the turnover measured in dollars or units sold.

ABC Classification Calculation Example

Here is a working example of the steps of how to divide your inventory using the annual consumption value:

Step 1: Obtaining the data.

You need the data to make the classification. Consider the annual consumption of each item.

Step 2: Ordering and Totaling the data.

List the products in descending order (from highest to lowest) based on their annual consumption value and total the number of units sold and the annual consumption value. This action is the preamble to the Pareto analysis.

Step 3: Calculate the data.

Calculate the cumulative percentage of items sold and the cumulative percentage of the annual consumption values using the totals.

Step 4: Determine the thresholds for splitting the data into A, B and C categories.

The threshold for determining the ABC limits will be unique to your company and your product mix, but typically it is close to 80%/15%/5%. To know how many items to take in each zone, you must define your thresholds limits. In this example, we will use 80% for type A, 15% type B and 5% for type C.

Step 5: Categorizing the data into zones.

You already know how many articles you are going to classify by zone. So, and with your data arranged from highest to lowest, the first ones will belong to category A. How many? The quantity you have defined in step 3. Proceed in the same way with the other categories.