ABC Analysis – Definition and Meaning

Definition: Abc analysis is an inventory management technique that is used to select a unit of inventory based on the key factors of demand, cost, and risk. ABC classification is used to segment existing inventory for future planning and management while increasing the value of assets at the sale and hold levels without addressing current market conditions. That is why it is important to use ABC to help you stay competitive and protect your profits.

The importance of ABC analysis

It can help streamline your inventory management process by quickly alerting you to changes in the market. It also provides vital information about inventory profiles for different products, including demand forecasting, cost forecasting, risk management, and management controls, which will help you cut costs while optimizing inventory resources with the most benefit to your bottom line.

Abc analysis is not a qualitative approach; it’s a quantitative one. The goal is to determine which inventory references pose the most risk to profitability; that’s why it’s best used by business owners who want to optimize their investment in inventory. Business owners generally use ABC analysis when preparing their annual sales reports. Business owners use it when they want to know the relative importance of different products in their business. For example, in a manufacturing company, the production manager might want to know how many different products might be produced in the next month.

How ABC Analysis Relates to the Pareto Principle?

Pareto’s rule states that, on average, 80% of the results from any action come from 20% of the factors involved. ABC analysis reveals a difference between method and outcome. By focusing on the effective result, the analyst can discover what works best in achieving his goal. ABC analysis indicates which products are worth pursuing in any given area

ABC analysis supports the idea of the Pareto principle. ABC analysis identifies the top 20% of products in a marketplace based on demand and price. Those products are purchased 80% of the time by customers who receive A rewards and 20% of the time by customers who receive B rewards. A is offered at a discount to B because it is perceived as a higher quality product. ABC also identifies new categories which can create additional competitive advantages for retailers.

Classes in ABC Inventory Management

Classes in ABC Inventory Management are the core of any organization. They account for all the items on your inventory in any category, including tools, devices, and inventory spaces. ABC Inventory Management classes are organized into sets or subtasks.

Class A

The first level of ABC inventory management is class A. Class A items have the greatest potential direct benefits in executing a business strategy to achieve specific goals and objectives. The importance of class A items in an organization can be thought of in two ways: an item may be class A because it performs a specific function or a specific role. In the case of method one, an item may be class A because it provides the highest return on investment (ROI) for the dollars spent on it.

Class B

This is your second-best performing inventory. It is the foundation upon which your overall performance is based. Class B includes items in which you have paid cash and ones you have claimed but not yet paid for as inventory for any reason—whether it was too costly to return or no longer needed. You should allocate Class B inventory as needed to maintain your profitable operation, but don’t let it become a bulk item. When there is a balance due on this class, it is generally treated as cash even though the actual cost of maintaining and using this inventory may be pass-through to your customer. Class B items tend to have low or minimal marketing capabilities (unless specifically marketed) because their primary purpose is small business operations and personal use.

Class B consists of lower-cost inventory that may be more appropriate for a specific small business or home use.

Class C

Class C may contain tools used only at work or at a lower cost than other classes, such as printed guides to accounting software or inventory systems. Class C inventory is used to track the status of your products. It comprises physical products, digital downloads, reordered samples or samples backordered, prototypes, liquidated damages, and many other types of inventory that don’t move much. Items in this class are usually thrown away once the cost to replace them has been paid or after a set amount of time, whichever comes first. A Class C inventory item typically represents the product(s) on hand with the low-profit potential for the foreseeable future. In other words, it is an urgently needed commodity that your business doesn’t need.

The concept behind ABC analysis is simple. Businesses must allocate resources for acquiring both new and used goods. The more critical an item is to a company’s success, the more it merits attention.

ABC effectively ranks the importance of different products and services based on data gathered through surveys, expert opinions, and other sources. Businesses then use these rankings to prioritize their inventory management efforts.

Your company’s business strategy can determine which category you fall into. For example: If you have a vibrant growth strategy but a less profitable division, you may have a stronger focus on growing the Class A products. But if you have a growing division with lower profitability, then the Class B and C products are where you should put your energy.

ABC inventory analysis is an essential step in planning your business. It helps you determine what inventory is needed, how much it should be filled, and which items will suffer from price per unit loss or price erosion over time as sales volume increases or volume decreases. ABC inventory analysis may be beneficial for a growing company because it helps identify how much inventory will be needed in the future and thereby helps reduce excess inventory costs. It can also help clients improve their overall efficiency by determining what should be sold and its price.

Below mathematical formula is used to calculate the ABC inventory analysis:

Annual usage value (per product) = Annual number of items sold x Cost per item

ABC Inventory Analysis is an inventory management software tool that will help you analyze your physical assets and determine their value on an ongoing basis. This tool will also help you make informed decisions about disposing of assets, completing necessary repairs and maintenance works, trading products in the market to improve profit, and creating marketing plans for your physical store.

To use ABC Inventory Analysis, you enter your information into the fields provided and then click the button that allows you to begin analyzing your assets. Inventory analysis offers you a complete picture of your business. It allows you to see where inventory is being used, what goods are in demand, and how much inventory is left over at any given time. 

Example of an ABC Analysis Calculation

An ABC analysis helps you determine how much of your resources should be deployed on certain classes of items. With this information, you can make decisions when deciding how much to spend on inventory upgrades and direct your attention toward improving overall business results. An example of an ABC analysis calculation would be comparing the cost of producing a batch of products to produce a similar batch on the company’s last good quality product. If the newbie cost for producing a batch of Class A is $5,000 and the last good quality batch costs $10,000, then an ABC analysis would show the potential savings of using less expensive production technology to produce the lower cost batch. At the same time, you could be discovering potential cost-saving opportunities that existed in the first place because you were focusing on efficiency instead of marketing hype.

Why Use ABC Analysis?

Using ABC analysis the business entrepreneurs and inventory managers classify their stocks based on their value and revenue generation. The ABC analysis allows them to focus on essential products and monitor their pricing. It also helps to keep the inventory under control, and businesses can plan their expenditures accordingly.

ABC analysis can help keep prices stable in the marketplace and allow managers to allocate their time and money toward marketing activities that lead to more profit.

Benefits of ABC Analysis

  1. Increased Inventory Optimization – The ABC analysis will assist a company in quickly determining what products are in high demand and, as a result, what orders can be fulfilled at minimal cost to the company. Once a determination is made regarding where inventory stands, the ABC management tool utilizes data-driven technology that allows a company to use its warehouse space efficiently and effectively. Utilizing real-time inventory information, this system allows a company to update its inventory in real-time and control incoming shipments efficiently. Class B and C goods, normally produced or purchased regularly, will typically see lower than normal demand due to their low pricing structures.
  2. Improved Inventory Forecasting – ABC analysis enables information from the customer database to forecast demand during a time of tight inventory. ABC allows managers to monitor, collect and report real-time data on product demand. This allows managers to make better decisions with fewer resources and hassle than is possible with traditional methodologies. ABC provides an alternative method for forecasting sales that gives business owners greater control and gives them a clearer picture of their organization’s current supply and demand situation.
  3. Better Pricing – When increased demand leads to increased sales, there are also increased opportunities to reduce prices. That means you can negotiate with your supplier and win more discounts than you would have if prices were static. ABC analysis is a powerful tool for retailers that enables them to see spikes in demand for a product, sometimes far over vendor quotes, as retailers gear up for a rush or limited release. By analyzing historical sales data, merchant acquisition behavior, proprietary analytics, and other data sources, ABC analysts can identify valuable indicators for pricing adjustment.
  4. Informed Supplier Negotiations – ABC analysis benefits are the immediate and long-term financial benefits a company will reap from obtaining additional goods or services through a negotiated supply contract with a supplier. ABC benefits typically include lower purchase prices, quicker delivery times, specialized production processes, trusted brand names, product development, and superior quality. ABC analysis is a powerful tool for suppliers to help negotiate better prices for their goods for you and other customers seeking purchases of goods or services from any source.
  5. Strategic Resource Allocation – ABC analysis is used to allocate capital, equipment, and staff to develop and launch Class A products at maximum efficiency. ABC analysis helps in continuous evaluation of resource allocation to ensure that Class A items align with customer demand and can be prioritized for production (or destruction) as necessary.
  6. Better Customer Service – ABC is all about customer service and getting your loyal customers the best possible experience with your business. As a business owner, you’re responsible for ensuring that your staff receives the most up-to-date information and tips on products and services. ABC determines the value (in terms of feedback and sales) of each customer by looking at many factors, including quantity sold in terms of items sold, unit cost, profit margin, and location. The higher the value, the better your overall customer service will be.
  7. Better Product Life Cycle Management – The ABC tool provides valuable insights into the launch strategy, product maturity, and decline. These are the factors in determining the demand for your product (as well as any related risks or challenges) and evaluating the value of inventory last accessed. ABC is an advanced forecasting tool that allows you to see 3-D visualizations of your whole product performance in real-time. It provides you with insights into where a product is in its life cycle.
  8. Control Over High-Cost Items – ABC analysis benefits could be the difference between a cash sale and a bounce. You have control over high-cost items (class A inventory). You can prioritize the order in which you monitor them, making it easier to spot trends in demand which can sometimes be challenging to identify without digging through hundreds of financial statements.
  9. Sensible Stock Turnover Rate: ABC is a helpful process that helps you maintain the stock turnover at your company. ABC is a process for monitoring the adequacy of your current holdings, evaluating the adequacy of your future holdings, and making investment decisions on a specific basis. Many business owners have used ABC to monitor and control their stock levels for many different business reasons, especially those involving implementing a new product plan.
  10. Reduced Storage Expenses: ABC analysis is a benefit analysis used to determine your stock situation’s most cost-effective storage method. ABC helps you decide whether or not it makes sense to purchase additional storage space or if you could achieve the same results at a lower cost. ABC is a benefit that will be gained as a result of storing inventory properly.
  11. Simplified Supply Chain Management: ABC analysis benefits from using simplified supply chain management systems for inventory control and simplifying business processes involving multiple partners. ABCs are best placed at the beginning of a business’s process to see if trends are clear and can provide early warning signs that operations can be streamlined or whole supply chains put under one management system, reducing the need for many individual actions. ABCs can also help manage risk by highlighting whether or not a particular source or combination of sources is causing trouble for other business areas and offering clear actions to manage those risks.

Many businesses are turning to ABC analysis to make sure they are getting the best deals from their suppliers and vendors over time. ABC analysis can help you determine the current demand for any product or service, as well as how much each item sells for today versus the last few periods.