What Is ABC Analysis & Its Importance in Inventory Management

Below is an example of an ABC analysis of inventory for a small retail business that shows the Pareto Principle at work, with many lower volume products also among the highest-value ones. The resulting Pareto Diagram shows the characteristic curve that illustrates the 80/20 rule, where items rank and roughly where to drop them into A, B or C classifications. A company might use ABC analysis to divide its inventory into three categories. “A” items are the most important and are, therefore, tightly controlled. These items might make up 10 percent of the inventory but account for 70 percent of the value.

The foundation of ABC analysis stretches back to the early 1900s, when inventor Vilfredo Pareto discovered the law of the vital few and applied it to economics. Almost every type of business can benefit from ABC analysis. Companies worldwide use the method to improve processes and increase profitability.

What Is ABC Analysis & Its Importance in Inventory Management

We also show you how you can also integrate smaller suppliers into the processes – with or without an EDI project. Enable warehouse managers to achieve near 100 percent inventory accuracy. By the combination of ABC and XYZ analysis a connection between the value portion of individual goods and the temporal need and/or consumption process of the respective article is manufactured.

• This allows a business to optimize their inventory, keeping high demand products in stock.
• Then you want to calculate gross profit margin and carrying cost.
• US retailers are currently sitting on about $1.35 in inventory for every dollar of sales they make.
• Applied to ABC analysis, this means the bulk of your inventory’s total consumption value gets allocated to A items, while B and C items make up less of that value.
• High-value items tend to be in high demand, and as demand rises, so can prices.
• Recall that stockouts cost merchants nearly $1 trillion in sales in a single year.

While an ABC analysis is a simple way to find your best and worst performing stock, it does have its downsides. Here are some things to consider when doing an ABC inventory analysis. In the meantime, start building your store with a free 3-day trial of Shopify.

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It results in an optimal ordering rhythm for the products, so that excessive capital commitments and write-offs can be avoided. ABC analysis promotes better negotiations on items that matter most to your business. These items account for high sales and so negotiations on these items Business Analyst will lead to significant cost savings for your business. You can negotiate on lowering costs or providing free shipping to you. Then you want to put your focus on negotiations followed by the consolidation process. Additionally, they ensure class A items are always available.

Category B, which includes the products and items with medium consumption value. Products in segment B generate somewhat revenue but mainly include products that are not in high daily demand. Cycle counts are a scaled-down version of physical inventory counts at set times during the business year. ABC analysis ensures more frequent counts of crucial, high-volume items.

Do you want to improve your business’s cash flow with the help of the analysis? You want to ensure you thoroughly think of what you are trying to achieve with the analysis. To mitigate its limitations, use it along with the XYZ method, with which you can also account for fluctuations in demand when determining the SKUs levels of safety stock. This could drastically reduce inventory management costs, and prevent both stock-outs and overstocking. Then, organize your inventory so that A-class items are stored closest to dispatch or the shop floor , B-class items are next in line, and C-class items last. That way goods that are handled most require the least amount of picking time.

Increase prices for your A grade inventory

Use an SKU’s quantity only when physically organizing your inventory . Inventory managers should use an automated system to retrieve inventory easily, and the system also helps manage lead times and demand planning. As the sales increase, demand for the product also increases, so you need to increase the stock to avoid stock-outs. Organizations should buy special equipment and hire more staff to perform it for more inventory items.

With this, the company can allocate more time and resources to the essential items. Companies need to decide the limit for each category based on what is meaningful to their businesses. Cycle counting provides a system of checks and balances to ensure the inventory records in the inventory management system are accurate. ABC analysis is just one of many reports you should consider when analyzing inventory performance.

ABC analysis: Things to keep in mind

All together, retailers miss out on $1 trillion every year due to stockouts alone. Performing an ABC analysis is an effective way for a business to determine the value of its products. It’s a simple process that helps manage large amounts of inventory, and how many resources should be allocated to each classification in order to yield the most profit.

Perhaps the most problematic restriction of the ABC analysis is its narrow consideration of patterns. Indeed, it comes down to profit in the end; however, there are many factors that the system fails to take into consideration—for instance, seasonal demand. A product might not be highly demanded in summer, but it can be a significant profit generator in winter.

In logistics an ABC analysis orients itself frequently also at the inventory turnover ratio. For example, it is not as useful for businesses that sell similar types of products. You can use the ABC XYZ analysis to better determine https://globalcloudteam.com/ the items’ safety stock. To use it, you are going to need reliable historical cost and demand data by item. That means in case new items enter your inventory, you can reliably categorize them only after a while.

What is ABC Analysis?

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B grade is middle-of-the-road inventory that accounts for the next 15% of your revenue, and should be treated as such. B grade can often fluctuate between an A grade and C grade. A large number of items keep changing their category every quarter, making the analysis unstable and complicated.

Usually, 10-20% of the inventory items come under group ‘A.’ Therefore, their annual usage or consumption value is about 70-80%. When we apply this to inventory management, we can say that 20% of the items contribute to 80% of the costs. ABC analysis best practices stress consistency, sales and attention to events that may affect stock levels or value. Using technology to manage inventory is a best practice that simplifies the process from end-to-end. A thorough ABC analysis begins with identifying the objective you’re trying to reach. Once you have that, collect the necessary information to categorize the items.

This can get inflated and overcomplicated very quickly, especially if multiple people within your organization have a say over how products get prioritized. If you’re selling hundreds or thousands of products, trying to manage each item can quickly become overwhelming. By the method a still more differentiated picture of the structure of the assortment of an enterprise results.

Improved customer satisfaction

Sort products (within your Excel spreadsheet or whatever tool you’re using) from highest usage value to lowest. Find the usage value of each item by multiplying the number of units sold by the total cost per item. In this article, we’re focusing on the ABC method of inventory classification. For more information on ABC Inventory , check out our review. You can also use ABC analysis to physically organize your warehouse.

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You’d also want to write down the cost per unit for each product on your list . As these changes occur, your products’ share of your total inventory value will change, which means you’ll need to adjust your ABC classification to match those changes. The last thing you want is to treat what is now an A-level item as a C item based on an outdated classification. Combining ABC and XYZ analyses into an automated process gives companies a much more comprehensive view of their goods and customers’ needs.

This helps mitigate any delays in the supply chain, so you’re never let down by a supplier who can’t deliver your grade A inventory. Sell-through rate is the percentage of inventory you’ve sold to customers. Fewer products sitting in storage means cheaper warehousing fees and better customer insight. A high STR means your customers are enjoying the products you’re selling—and they’re voting with their wallets.

Grade A items should be counted first, followed by category B and finally, category C. Giving C grade products away to customers as freebies gives you the chance to offload excessive inventory while also creating an enjoyable and memorable experience for your customers. For example, for every serving bowl you sell, give shoppers a free mug . Your C grade products are at the bottom of your sales priority list.

Inventory management platform to track individual product levels in real-time, collect critical product information, and improve efficiency across all order management. As you grow and add items to your inventory, your classification mix will change. If you continue to monitor your analyses, you’ll start to notice patterns and be able to forecast which inventory is most vital for you to manage and which are least important. By always having the right inventory mix, your operations will run more efficiently, and cash flow nightmares will eventually be a thing of the past.

Written by Roberto Contreras