What is ABC Analysis?
ABC analysis refers to the inventory management technique that is used to identify items that constitute a significant part of the overall inventory value and categorize them into critical, important and moderately important. The basic premise of ABC analysis is that every single item in an inventory doesn’t have equal value and demand – some items cost much more than the others. In contrast, some items are used more frequently, and the remaining are a mix of both.
How to Perform ABC Analysis?
Typically, companies use the following steps to perform ABC analysis –
Step 1: Firstly, determine the inventory value of all the items by multiplying their price and their consumption volume during the given period. Mathematically,
Inventory Value = Item Cost * Consumption Volume
Step 2: Next, sort all the items according to inventory value from highest to lowest.
Step 3: Next, calculate the value contribution of each item as a percentage of the total inventory value. Mathematically,
Item % of Total Inventory Value = Item’s Inventory Value / Total Inventory Values
Step 4: Finally, group all the items according to their contribution to the overall inventory value. For instance, items that account for 80% of total inventoryInventoryDirect material inventory, work in progress inventory, and finished goods inventory are the three types of inventories. The raw material is direct material inventory, work in progress inventory is partially completed inventory, and finished goods inventory is stock that has completed all stages of production. may be allocated to the category ‘A’ items. In comparison, items that account for the following 15% may be allocated to category ‘B’, and the remaining 5% may be allocated to category ‘C’.
ABC analysis classifies the inventory into three categories – Category A, Category B, and Category C.
- Category A: Items in this category are essential and at times, business-critical for a company. Typically, these items either have a high value or large market. Hence, this category requires frequent value analysis.
- Category B: Items in this category are important, but not as important as those in category A. Typically, these items constitute mid-range in inventory value and have relatively lesser market demand.
- Category C: Items in this category are marginally important and constitute a tiny portion of the overall inventory value.
It is to be noted that there is no fixed threshold for any of these categories, and hence different value proportions can be used based on the company’s own objectives and criteria.
Example of ABC Analysis
Let us take the example of Susan, who is engaged in the retail sale of handbags. Last year she decided to expand her product offering by including more varieties of sweaters in her inventory. Consequently, she purchased 30 different types of handbags instead of just 10. However, later she realized the demand for the products is seasonal, and she had invested a lot. Hence, she decided to implement the ABC analysis in her business model to streamline the inventory.
So, Susan classified the inventory into category A, B, and C, primarily based on their selling price and demand as mentioned below:
- Category A: The handbags that are either highly in demand, generate the maximum revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions., or are trending in the current season were classified under this category of items.
- Category B: The handbags that are essential to the company, but not as much as those in category A. Probably the demand for these handbags are slightly seasonal and not across the entire year. So, during the season, the sales of these items are expected to shoot up. Hence, these set of handbags can’t be neglected and hence category B.
- Category C: In this category, all those handbags are included that are not of high value to the company. The possible reasons may be a colour combination, pattern, etc. Hence, these handbags are placed in category C.
ABC Analysis Graph
The above graph states that the items in category ‘A’ cover a small portion based on the number of units in the inventory but constitute a significant portion of the inventory value. The items in category ‘B’ have a moderate contribution to both quantity and inventory value. The items in category ‘C’ cover a significant portion of the inventory in terms of quantity but have a tiny contribution to inventory value.
- A large number of items keep changing their category (category A to B or B to C and vice versa) every quarter which makes the analysis unstable and complicated.
- ABC analysis fails to take cognizance of some basic demand patterns, such as seasonality, novelty effect, etc.
- The choice of parameters used for ABC analysis is arbitrary in nature.
Importance and Uses
The ABC analysis finds wide application in supply chain management and inventory management, where it used as a cycle counting system. It helps companies in managing their working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" requirement as well as holding costsHolding CostsHolding cost refers to the cost that an entity incurs for handling and storing its unsold inventory during an accounting period. It is calculated as the sum total of storage cost, finance cost, insurance, and taxes as well as obsolescence and shrinkage cost.. Further, it also helps in working out appropriate inventory rules for each item category, such as different safety stock levels and re-ordering points.
- It provides a structured view of the entire inventory in terms of quantity and value.
- It allows management to implement different control measures for each item category.
- It helps in continuous monitoring of inventory, which in turn ensures maintenance of optimum stock level.
- It requires a significant amount of effort to categorize items in this way.
- It is only based on the financial value of items, while it completely ignores other factors that may be important for the company.
This has been a guide to what is ABC analysis and its meaning. Here we discuss how to perform this analysis with example, graph, limitations, and disadvantages. You may learn more about financing from the following articles –