Suppose you have been searching for the best technique to manage your inventory with hundreds or thousands of different items. In that case, we have got the answer: ABC Analysis (also known as ABC Classification).
What is an ABC Analysis in Inventory Management?
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 on 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 in 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.
Benefits and Importance of ABC Inventory Analysis
The objectives of ABC analysis are to streamline your inventory management and drive strategic management decisions across your business. The ABC method helps manufacturers and retailers generate the most revenue while reducing inventory cost and improving cash flow.
Improved Inventory Forecasting:
By using the ABC analysis for inventory management, companies can increase inventory optimization and improve forecasting accuracy. This analysis helps identify which products are the highest revenue generators and which are the least important, so manufacturers can better adjust order management and optimize stock levels.Increased Inventory Turn & Reduced Carrying Costs:
When you implement ABC inventory management, you gain robust inventory information that helps increase inventory turns while reducing carrying costs. This is essential for maintaining a healthy cash flow and ensuring the inventory mix adapts as customer demand and product usage change.Data-Driven Decision-Making:
ABC analysis is built on effective data collection and analysis. Using tools such as Microsoft Excel to perform ABC analysis calculations and track ABC classification percentages enables decision makers to group items strategically and understand which products and services generate the most revenue.Optimized Order Management:
ABC analysis works by grouping items and identifying the products that require tighter controls and more frequent reviews versus those that can be managed with fewer resources. This targeted approach means you can negotiate better terms with suppliers and achieve better customer service by focusing on high-impact items first.Support for Strategic and Tactical Decisions:
ABC inventory analysis lets you understand which items generate the most revenue and which are less critical, so decisions based on robust inventory information become more accurate. It helps businesses optimize their warehouse space, reduce stockouts, and ultimately increase profit margins.
Categories, Zones, or Types of ABC Analysis
There are no fixed thresholds for each category. In such a 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.
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 (Class A Inventory)
- Comprises the smallest group of items, yet they generate the most of the profit margin.
- Consists of high-cost, high-utilization products with a significant contribution to overall sales volume and revenue.
- Represents approximately 12-18% of all inventory items but accounts for 65-75% of the total inventory value.
- Requires tight controls, accurate record-keeping, and frequent reviews to avoid stockouts and ensure better control over physical inventory.
- Category B – Moderately Important
- Contains products of intermediate value that are important but not critical.
- Typically makes up about 20-30% of items and contributes 15-25% of total stock value.
- Demands moderate control and oversight, which helps manufacturers use cycle counting and inventory management software to optimize stock and reduce carrying costs.
- Category C – Marginally Relevant
- The largest category by volume consists of low-value items.
- Requires minimal supervision, as these items contribute the least to overall business revenue and profit margins.
- Suitable for items with lower sales volume, allowing companies to allocate time and effort to higher-value products.
- Category D – Relatively Unimportant (Optional – Obsolete Inventory)
- Used for items that are obsolete, unsellable, or have not moved for extended periods.
- Can be tailored to include inventory based on specific internal criteria, helping businesses better manage inventory turnover and warehouse space.
Effective inventory management relies on the ABC analysis classification method to group your inventory based on value and impact on your business’s revenue. By leveraging this ABC inventory analysis technique, companies can optimize inventory levels, reduce carrying costs, and improve real-time control—all crucial for robust supply chain management.
ABC Classification System 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 “weigh” 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 threshold limits. In this example, we will use 80% for type A, 15% for 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, 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.
Integrating a robust ABC inventory classification system into your Sage X3 ERP can revolutionize your inventory management approach. Panni empowers businesses to implement an effective ABC analysis classification that refines the ABC classification of inventory. This approach improves visibility and decision-making, ensuring efficient order management and improved profitability. Optimize your supply chain, reduce costs, and stay ahead in the competitive market. Contact us today.
