We previously spoke about the process of cycle counting, and how it increases your accuracy. In that post, we also mentioned the ABC style of analysis, though we didn’t go into much detail. That changes today! In this article, we’ll go over what ABC analysis is, how to perform it, and how it relates to cycle counting and the Pareto principle.
We also cover ABC analysis in our new podcast. Watch the short clip below!
What is ABC analysis based on?
When talking about a concept like this, it helps to understand what it’s based on. In this case, ABC analysis is based upon the principle that 80% of the output is a result of 20% of the input. This is called the Pareto principle, and is also known as the 80/20 rule.
It seems simple, right? Keep in mind, though, that the Pareto principle is not absolute. Therefore it doesn’t apply to every business, and the 80/20 ratio itself is not an exact figure, just an estimate.
There’s a few ways to apply the Pareto principle to a business. For now, though, we’re going to focus on how it applies to inventory management. In this case, the Pareto principle states that 80% of a company’s revenue comes from 20% of its inventory. This is the idea that ABC analysis is based on.
Again, though: these numbers are just estimates. Obviously, different businesses have different systems, and these values tend to fluctuate between industries. At the same time, there’s enough truth to the claim that it’s commonly accepted.
But how does this relate to ABC analysis? To answer that, it’s important to understand what exactly ABC analysis is.
What is ABC analysis?
All that might seem a bit confusing, but it’s simple. In brief, ABC analysis is just that– an analysis. So naturally, it’s used to make more informed decisions on how much inventory to carry. Businesses using this classification of inventory place their products into three categories; A, B, and C.
- Items in “Category A” are high-value products and typically make up ~20% of total inventory. These products make up 80% of total revenue.
- Items in “Category B” are medium-value products, and typically make up ~30% of total inventory. These products make up 15% of total revenue.
- Items in “Category C” are low-value products, and typically make up ~50% of total inventory. These products make up 5% of total revenue.
Still, keep in mind that these numbers are estimates. It’s unlikely your own numbers will mirror these exactly, but there’s a good chance they’ll be in the same ballpark. This is also why cycle counting is frequently used alongside ABC analysis.
Emphasizing the more important products means that they’re counted more frequently. This goes hand-in-hand with the cyclical nature of cycle counting. Counting the more important products more frequently yields greater accuracy at a much lower time investment. This isn’t limited to retail stores, either: manufacturers can benefit from ABC inventory as well.
What benefits does ABC analysis offer?
The nature of ABC classification means that you’ll be collecting information frequently. This information, in turn, leads to a lot of benefits. There’s too many to count, so here are some of the important ones.
- Better pricing: increased information allows businesses to set better prices for their products, and better prices lead to more sales.
- Improved resource allocation: ABC analysis optimizes the use of warehouse space. This results in less capital being tied up in the warehouse, opening up resources that can be used elsewhere.
- Better inventory prediction: the increased information flow helps businesses figure out what products are in-demand. This helps maximize the amount of sales without overstocking.
How do you perform ABC analysis?
First– as with anything else– make sure that your numbers are accurate. If you’re doing this by hand, you’ll probably want a calculator as well. Start with a list of products that also includes annual demand, as well as per-unit cost. This ensures that the sample size is large enough and helps decide what products to buy for the next year.
For this example, let’s say you own a business that sells backpacks. Your ABC analysis may look something like this:
To calculate product value simply take your annual demand and multiply it by your unit cost. Once you have all your product values, add those up to get your total revenue. In this example, the total revenue would be $2,145,000. Next, calculate what percentage of revenue each product accounts for. For example, the 30L Gear Bags have a product value of $1,625,000 divided by the total revenue, which is $2,145,000. This means the percentage sales value for the 30L Gear Bags is 75.76%.
According to the “rules” of the ABC inventory method, 30L Gear Bags fall into category A. 20L Day Bags make up category B, while Fanny Packs and Dividers make up category C. Of course, these values don’t quite line up with the 80/20 rule of ABC analysis– and that’s ok! The important thing is that they’re in the ballpark. Congratulations! You’ve done your own ABC analysis.
Maintaining the system
Once you calculate (and implement) your own ABC classification of inventory, it’s important to maintain it. There are two key factors in keeping your system accurate:
- Keep things simple. Successfully implementing an ABC analysis system relies on having accurate information. At the same time, having too much information can overcomplicate things, so it’s best to limit it to what’s necessary. In fact, only collect information that’s absolutely necessary.
- Remain flexible. The market changes every day. Because of this, something that’s in demand one day might not be in demand the next. Because of this, ABC analysis doesn’t remain accurate forever. It won’t become irrelevant the next day, but it is necessary to reclassify items. Keeping things flexible (and simple!) makes it easy to reclassify when necessary.
Limitations of ABC analysis
ABC analysis may be a useful tool, but it has its limitations.
- Demands attention: obviously, ABC inventory management is not something that you can set and forget. It requires constant attention, and if done incorrectly, it can cost money instead of saving it.
- Black and white classification: while the ABC classification of inventory is useful, it’s also fairly rigid. Just because category B and C class products are low value, that doesn’t mean that they have no value. For instance, if you don’t keep track of lower-value items, they might fall through the cracks, making things inaccurate.
- Subject to large change: previously, we talked about how ABC analysis is sensitive to market changes. For this reason, products need frequent reclassification, which eats up time and money.
At the end of the day, every business has different needs. ABC inventory isn’t for every business; make sure it’s something you can benefit from before performing it.
Get into the flow– with inFlow!
Whether you’re a retail or manufacturing business, it’s important to identify which products or components are important to your business. They might all be necessary, but some are going to be more important than others. That’s just how things work.
Like many other systems, ABC analysis relies on having– and maintaining– an accurate inventory count. ABC stock keeping can increase overall cash flow, but if you’re manually counting everything, you’ll spend more than you save. This is where inFlow’s stock control systems. Instead of manually counting through everything, our perpetual inventory system provides real-time updates around the clock, letting you focus on the important things.
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