ABC Analysis in Inventory Management: Benefits & Best Practices (2024)

What Is ABC Analysis in Inventory Management?

ABC analysis is an inventory management technique that determines the value of inventoryitems based on their importance to the business. ABC ranks items on demand, cost and riskdata, and inventory mangers group items into classes based on those criteria. This helpsbusiness leaders understand which products or services are most critical to the financialsuccess of their organization.

The most important stock keeping units (SKUs), based on either sales volume or profitability,are “Class A” items, the next-most important are Class B and the least importantare ClassC. Some companies may choose a classification system that breaks products into more thanjust those three groups (A-F, for example).

ABC analysis in cost accounting, or activity-based costing, is loosely related but differentfrom ABC analysis for inventory management. Accountants use activity-based costing inmanufacturing to assign indirect or overhead costs like utilities or salaries to productsand services.

Video: What Is ABC Inventory Analysis?

How ABC Analysis Relates to the Pareto Principle

The Pareto Principle says that most results come from only20% of efforts or causes in any system. Based on Pareto’s 80/20 rule, ABCanalysisidentifies the 20% of goods that deliver about 80% of the value.

Therefore, most businesses have a small number of “A” items, a slightly largergroup of Bproducts and a big group of C goods, a category that that defines the majority of items.

The Pareto Principle may not always be completely accurate. However, analysisshows that valuable things do tend to bend toward an 80/20 distribution. ABC analysisidentifies the “sweet spot” where most of a business’s revenue comes fromwith relativelylittle effort.

How Is ABC Inventory Analysis Calculated?

Conduct ABC inventory analysis by multiplying the annual sales of a certain item by its cost.The results tell you which goods are high priority and which yield a low profit, so you knowwhere to focus human and capital resources.

Use this formula for ABC inventory analysis:

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

You can use Microsoft Excel to do a basic ABC inventory analysis. List eachproduct or resource in descending order according to its product usage value. Calculate thetotal of each item in the aggregate amount. Determine the values for the A, B and Ccategories, then assign a group name to each item. The goods with the highest value then getthe manager's closest attention.

Example of an ABC Analysis Calculation

Below is an example of an ABC analysis of inventory for a small retail business that showsthe Pareto Principle at work, with many lower volume products also among the highest-valueones. The resulting Pareto Diagram shows the characteristic curve that illustrates the 80/20rule, where items rank and roughly where to drop them into A, B or C classifications.

For more information about benefits and best practices, check out our inventorymanagement guide.

How ABC Analysis Simplifies Work for Inventory Managers

Inventory managers are always looking for ways to improve pricing and quality or to achievegreater efficiencies. In light of that goal, they may use the ABC technique, sometimescalled the “always better control” method. They can use the analysis to focustheir time andeffort primarily on Class A inventory and less on B and C class products. For example,inventory managers will use ABC analysis to check the purchase orders of the highest value(Class A items) products first, since these generate the most revenue.

Why Use ABC Analysis?

Using ABC analysis for inventory helps better control working capital costs. The informationgained from the analysis reduces obsolete inventory and can boost the inventory turnoverrate, or how often a business has to replace items after selling through them.

ABC Analysis Benefits

A long list of benefits can result from applying ABC analysis to inventory management,including:

• Increased Inventory Optimization: The analysis identifies the productsthat are in demand. A company can then use its precious warehouse space to adequatelystock those goods and maintain lower stock levels for Class B or C items.
• Improved Inventory Forecasting: Monitoring and collecting data aboutproducts that have high customer demand can increase the accuracy of sales forecasting.Managers can use this information to set inventory levels and prices to increase overallrevenue for the company.
• Better Pricing: A surge in sales for a specific item implies demand isincreasing and a price increase may be reasonable, which improves profitability.
• Informed Supplier Negotiations: Since companies earn 70% to 80% oftheir revenue on Class A items, it makes sense to negotiate better terms with suppliersfor those items. If the supplier will not agree to lower costs, try negotiatingpost-purchase services, down payment reductions, free shipping or other cost savings.
• Strategic Resource Allocation: ABC analysis is a way to continuouslyevaluate resource allocation to ensure that Class A items align with customer demand.When demand lowers, reclassify the item to make better use of personnel, time and spacefor the new Class A products.
• Better Customer Service: Service levels depend on many factors, likequantity sold, item cost and profit margins. Once you determine the most profitableitems, offer higher service levels for those items.
• Better Product Life Cycle Management: Insights into where a product isin its life cycle (launch, growth, maturity or decline) are critical for forecastingdemand and stocking inventory levels appropriately.
• Control Over High-Cost Items: Class A inventory is closely tied to acompany’s success. Prioritize monitoring demand and maintaining healthy stocklevels, sothere’s always enough of the key products on hand.
• Sensible Stock Turnover Rate: Maintain the stock turnover rate atappropriate levels through methodical inventory control and data capture.
• Reduced Storage Expenses: By carrying the correct proportion of stockbased on A, B or C classes, you can reduce the inventory carrying costs that come withholding excess inventory.
• Simplified Supply Chain Management: Use an ABC analysis of inventorydata to determine if it’s time to consolidate suppliers or shift to a singlesource toreduce carrying costs and simplify operations.

ABC Analysis Limitations

ABC analysis, despite all its benefits for inventory maintenance and management, is not aone-size-fits-all inventory management solution. Every organization has specific customerdemand patterns, classifications, systems and other issues that affect the usefulness of anABC analysis.

The disadvantages of ABC analysis stem from two issues: an emphasis on the dollar value ofinventory and the significant amount of time and discipline it takes to apply the method.Here are a few more challenges:

• Parameter Instability: ABC analysis often results in managers assigningup to 50% of items to a new category every quarter or year. Often, companies are notaware of the changes until there is a problem with demand, and the need to reassess maytake up valuable time and jeopardize customer satisfaction.
• Limited Pattern Consideration: The standard ABC method will not accountfor factors like new product introductions or product seasonality. For example, a newproduct may have low sales volume because it has no buying history. ABC analysis has asomewhat static perspective on demand and will generate inventory inefficiencieswhenever demand is shifting or unclear.
• Low Information Extraction: ABC class information may not provide allthe statistical data or detail needed to make informed, strategic management decisions.
• High Resource Consumption: Giving disproportionate weight to trivialissues is known as bikeshedding, which can be an unfortunate consequence of ABCanalysis. Since ABC analysis is easy to grasp, staff may inject their opinions orrequest their own variants making ABC analysis a resource-consuming process rather thana time-saving tool.
• Value Blindness: ABC analysis ascribes product importance based onrevenue or frequency of use, but some items may not hold to this paradigm. For example,a retail display item may rarely sell but may attract a lot of customers (who will buyother products) based on its novelty. In aerospace, a specific part for a plane may notbe used often and have little market value, but it may be a fundamental safety function.
• System Incompatibility: ABC inventory analysis conflicts withtraditional costing systems and is out of compliance with generally accepted accountingprinciples (GAAP) requirements. If you must run multiple costing systems, labor costswill rise alongside inefficiency.
• Undersupply or Oversupply Issues: One ABC analysis disadvantage is itlooks at dollar-based values, rather than the volume that cycles through inventory, sothere is a risk of running out of Class B or C items. The opposite can occur, too. Youmay have excess low-class items that accumulate in inventory if you reorder them withoutregular reviews.
• Loss Risk: Just because B and C items do not have as high a value asClass A products does not mean they no value. One of the limitations of ABC analysis isthat excess stocks are always in jeopardy of obsolescence or damage. Therefore, theinventory that habitually goes uncounted or unmonitored may be subject to theft.
• Mandatory Standardization: The ABC method is only successful if everyitem is subject to the standardization of materials, which includes how they are named,stored, and consistently rated and monitored.
• Arbitrary Categorization: Without preset boundaries or agreed-uponstandards for each category, classifying goods depends on the manager's professionaljudgment. So this can be a relatively subjective process.
• Business Limitations: ABC analysis is not useful for companies thathave an equable annual consumption value of inventory items by type. For instance, acompany that sells the same version of an item like candy, nails or socks, may not beable to sort stock based on the Pareto Principle.
• High Resource Consumption: Companies with a significant number ofinventory items will have to hire additional staff or buy special equipment to controlinventory using ABC categorization.

How to Perform ABC Analysis

A thorough ABC analysis begins with identifying the objective you’re trying to reach.Onceyou have that, collect the necessary information to categorize the items. Once the classesare in place, closely track and make decisions based on the resulting data.

Here’s how to perform an ABC analysis step-by-step:

1. Identify the Objective: An ABC analysis can help you meet one of twotargets: lower procurement costs or raise cash flow by optimizing inventory levels ofthe right items based on customer sales or production.
2. Collect Data: The most common data to collect is the annual spend on eachitem. This data is in raw purchase dollars. If it’s easy to calculate, youcangather the weighted cost, including gross profit margin, ordering and carrying costdata.
3. Sort by Decreasing Order of Impact: Use the ABC analysis formula torank each inventory item’s order by cost — from highest to lowest impact.
4. Calculate the Sales Impact: For each inventory item, calculate itsimpact on sales as a percentage by dividing the annual item cost by the aggregated totalof all items spent. This number is the percent, or fraction, that you will use tocompare items in the list. Here’s the formula:

   % Impact = (annualitem cost) / (aggregated total of allitems spent) x 100

5. Sort Items into Buy Classes: Once you define the classes, work oncontract renegotiation, vendor consolidation, shifting strategic sourcing methodology orimplementing e-procurement. Making changes in these areas can provide significantsavings or ensure the in-stock availability of Class A items. Take a holistic viewrather than being strict about the 80/20 rule.
6. Analyze Classes: Once categories and strategic cost management aredefined, schedule reviews to monitor the success or failure of decisions.

ABC Analysis Best Practices

ABC analysis best practices stress consistency, sales and attention to events that may affectstock levels or value. Using technology to manage inventory is a best practice thatsimplifies the process from end-to-end.

Apply these best practices when doing an ABC analysis:

• Keep Classifications Simple: Categorize items based on how frequentlythey move through your organization. Fast-moving items are more subject to stockouts.You can also categorize items based on value or gross profit margin. The most expensiveitems would be placed in Class A, average price items in Class B and the least expensivein Class C.
• Assign Service and Labor Levels at the Same Time: Assign service levelsbased on an item’s class. The Class A goods have the highest targets, while thelastclass products have the lowest ones. For instance, managers would spend 10 hoursreviewing 100 Class A items and 10 hours reviewing 10,000 Class C items. Schedule cycle counting byclassification, ensuring more regular cycle counting is performed on Class A items(those which make the biggest and most significant impact on sales performance) moreregularly than Class B and C items.
• Segment KPIs by Class: Create distinct KPIs, corresponding reports anddashboards for each class.
• Establish Performance Reviews: Conduct performance reviews when doingfull inventory maintenance or around schedules and rules that depend on ABCclassifications.
• Review Surplus Stock: Decide if your current surplus stock levels makesense for your company. In the global, just-in-time economy, the surplus stock may poseunnecessary risk and holding costs. If it makes sense to hold onto this inventory,classify it correctly.
• Manage Across Locations: Supply chain managers need the ability tomanage inventory across physical locations.
• Count Inventory in Transit: When stocks move between locations, trackthe time between shipment date and receipt date. Audits like these keep inventoryrecords in order and ensure you register damage or loss.
• Reclassify Purposefully: Remain flexible in how and when you reclassifyitems. You may need to reclassify inventory periodically because of market changes,alterations in your customer base or their buying habits, new products that becomepopular, or a shift in your KPIs or business strategy.
• Consider Sales and Inventory in Tandem: Recognize the relationshipbetween sales and inventory. As sales increase, inventory turn increases, andyou’llneed to restock against an assumed schedule. Conversely, a downturn in the marketplacemay call for a re-examination of item classes and stock levels. Review pricing as wellas promotional strategies based on classification.
• Leverage Technology and Resulting Data: Inventory managers useautomated systems to complete replenishment processes, recognize upticks in demand andavoid fulfillment problems. Use data to manage lead times and demand planning.

Using ABC Analysis for Cycle Counting

Cycle counts are a scaled-down version of physical inventory counts at set times during thebusiness year. ABC analysis ensures more frequent counts of crucial, high-volume items.

Cycle counting provides a system of checks and balances to ensure the inventory records inthe inventory management system are accurate. Regular cycle counting can be scheduled byclassification, ensuring more regular cycle counting is performed on Class A items —thosewhich make the biggest and most significant impact on sales performance — than Class Band Citems.

How to Implement ABC Inventory Management

The best way to implement ABC inventory management is to first assess whether it would beeffective for your business. Avoid assumptions by asking critical questions. Once you decideto move forward, make any necessary preparations for a smoother execution.

Use this questionnaire to assess your readiness for ABC analysis implementation. If youanswer “No” to any questions, you need to do more preparation before completingan ABCanalysis:

Applying ABC Analysis and Calculations Use Cases in Various Industries

Almost every type of business can benefit from ABC analysis. Companies worldwide use themethod to improve processes and increase profitability.

So how can businesses in various industries employ the 80/20 ratio and ABC analysis?

• Retail: Retailers use ABC analysis identify the products mostprofitable to the business. They can then use the data to promote those products acrossretail locations and ensure there is adequate stock on hand.
• Automotive: The ABC method enables automotive manufacturers to analyzethe effectiveness of line workers, obtain details that inform resource utilization, anddetermine what equipment is the highest-performing. Inventory control also providesinsight into the necessary raw materials and valuable information to negotiate new orbetter contracts with suppliers.
• Warehousing: In the warehouse, ABC analysis and segmentation allow theinventory controller to focus on ways to better manage higher value inventory, includingthe correct amount of safety stock to avoid stockouts. Data can also prompt rethinkingproducts sold and sunsetting goods.
• Manufacturing: In a manufacturing setting, ABC analysis helps increaseprofit margins by classifying the top 20% of products by revenue. Manufacturers can usethe analysis to determine the most parts and materials those products require andmargins. They can use these findings to prioritize people, time and materials to makethe greatest impact.

History of ABC Analysis

The foundation of ABC analysis stretches back to the early 1900s, when inventor VilfredoPareto discovered the law of the vital few and applied it to economics. Today, ABC is apillar of inventory management.

• 1900s: Economist Vilfredo Pareto discovered the 80/20 rule that statesincome follows distribution in inverse proportions. Since he discovered the principle in1906 and noted its applications to economics, industry, science and sociology, it hasbeen used worldwide in a variety of disciplines.
• 1950s: Joseph M. Juran and W. Edwards Deming were founders andproponents of quality management (QM), which relies on ABC analysis. They brought theconcept to Japan, which helped create the post-war Japanese Economic Miracle.
• 1960s: Based on quality management concepts, total quality management(TQM) employed the ABC concept and enjoyed widespread popularity during the late 1980sand early ‘90s.
• 1970s: UPC barcoding and scanning came into use in retail in 1974. TheDepartment of Defense implemented a barcode inventory control system in 1981. Barcodesand scanning allowed for much easier tracking of products throughout their life cycle,supporting ABC-based inventory management.
• 1980s: Lean Six Sigma is all about eliminating excess in manufacturing.Using ABC analysis in conjunction with lean approaches started in the ‘80s andcontinuestoday.
• 1990s-present: As a central database that has robust inventoryinformation, enterprise resource planning (ERP) systems support ABC inventory analysisand its use in combination with other inventory management methods. Today, ERP systemsare used worldwide to assist with classified item inventory management.

NetSuite’s ERP Software Helps Inventory Managers Make the Most of ABC Analysis

To simplify and automate selective control, ERP systems that include ABC analysis has becomea standard tool for inventory managers. With ERP, users can execute full ABC analysis basedon user-defined criteria, risk analysis and schedule optimization.

NetSuite’s ERP software helps businesses maintain optimum supply levels with real-timeinventory visibility that helps them avoid overstocks and stockouts. ERP's predictiveanalytics anticipate demand dips or spikes and alert inventory teams if there’s achange indemand or stock levels. Find out how ERP can streamline mission-criticalinventory management processes.