ABC Analysis in Inventory Management: Benefits and; Best Practices

Urmi Sengupta |Updated on: September 14, 2022

What is ABC analysis in inventory management?

ABC analysis calculation

How ABC analysis is performed

Benefits of performing ABC analysis

Limitations of ABC analysis

Best practices of ABC analysis

TallyPrime for inventory management

What is ABC analysis in inventory management?

ABC analysis in inventory management refers to identifying the items of inventory based on how valuable they are to your business. The items are grouped into three classes; class A, class B, and class C. The items are identified according to the risk they carry with them, their demand, and their cost. ABC analysis lets you find out and determine which inventory items are most useful and imperative for your business. Class A items are the most important SKUs and class C items refer to the least important items. Some businesses choose to further break down the classification by starting from class A items and then going on until class F.

Why should a business consider using the ABC analysis? ABC analysis allows you to better understand capital costs and keep them under control. This allows you to minimize obsolete inventory while encouraging the turnover rate of your business inventory. It also makes it easier for inventory managers because they know which inventory items they should prioritize and which ones are most important for the business. As the class A items are tied to generating the highest revenue, inventory managers include they have the appropriate purchase orders.

Note that ABC analysis exists in activity-based costing too where it is used in cost accounting. ABC analysis in inventory management is a different concept although they are loosely tied together.

ABC analysis calculation

The ABC analysis calculation involves the following formula.

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

Once you are aware of the product usage value, you can then understand which goods have the most value and then categorize accordingly in classes A, B, and C.

How ABC analysis is performed

The steps of performing ABC analysis are as follows.

Step 1: Identify your goal

The first step is to identify your goal. Do you want to improve your business’s cash flow with the help of the analysis? Or do you want to lower your costs of procurement? You want to ensure you thoroughly think of what you are trying to achieve with the analysis.

Step 2: Collect the data required

You need to collect proper data if you want to categorize the items properly and make decisions based on that. You have to know the annual expenditure done on each item. Then you want to calculate gross profit margin and carrying cost.

Step 3: Use the formula to categorize

Using the ABC analysis formula mentioned above, you want to calculate the annual usage value per product. Once you are done with the calculation, you want to rank according to cost. The highest cost items should be on top.

Step 4: Calculate impact on sales

Calculate the impact on sales of each inventory item by dividing the annual cost of the item divided by the aggregated total of all items spent. Then multiply this by 100 to get a percentage value. This comes in handy to compare the various items on the list.

Step 5: Sort items into classes

You need to define the classes first. Then you want to put your focus on negotiations followed by the consolidation process. These can help cut down on costs and encourage savings. Additionally, they ensure class A items are always available.

Step 6: Analyze in detail

This step involves analyzing the classes after the cost management strategies are determined. Constant reviews must be part of the process as they help unveil whether the decisions made were correct or if they should be changed.

Benefits of performing ABC analysis

The benefits of ABC analysis are as follows.

Encourages negotiations

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 will lead to significant cost savings for your business. You can negotiate on lowering costs or providing free shipping to you.

Better warehouse management

When you have the information about which products are beneficial for your business, you know which ones to stock and which ones to prioritize. This ensures you always have sufficient stock of in-demand items and never have to suffer from low stock levels.

Promotes strategic supply chain management

It allows you to understand whether you should continue maintaining your suppliers' list or if you should opt for a single source only. Sometimes, having a single source will drive down inventory carrying costs. This can make it easier to maintain operations and ensure they run smoothly.

Improved inventory forecasting

When you are collecting data and finding out which products mean the most for your business, you have good knowledge about which ones are in high demand. This can help improve forecasting which in turn can help accelerate the rate at which you generate revenue.

Decrease in storage costs

Inefficient storage can drive storage costs which increase your business expenses. When you know that class A items are the most important, you can store more of them and less of class B and C items. This cuts down on storing dead inventory and ensures excess inventory is avoided.

Increase profits

When an item’s popularity surges, you can increase your profits by offering the product at a higher price to your customers. This knowledge comes from data collection that you perform during ABC analysis and it can provide an easy way to improve profitability in a short span of time.

Limitations of ABC analysis

The limitations of ABC analysis are as follows.

Risk of loss and theft

As more emphasis is placed on class A items, it is easy to not give importance to class B and C items. It can lead to loss and theft of those items as they are not prioritized and so they may not be audited as often as the class A items.

Not ideal for every business

ABC analysis is limited to some types of businesses only. For example, it is not as useful for businesses that sell similar types of products. Let us say a business sells different types of chocolate. Such a business won’t find value in ABC analysis.

Run out of class B and C items

When you have excess inventory of class A items because they are in demand, there is a risk that when demand for class B and C items rises you will have undersupply issues. Another issue may stem from storing class B and C items; which is  an oversupply if you don’t regularly review the need for these items.

Best practices of ABC analysis

The best practices of ABC analysis are as follows.

Rethink surplus stock

How much surplus stock is good for your business depends on your business needs. If you feel like the extra stock is increasing carrying costs significantly then consider if you are better off with just-in-time inventory management. If you decide to have surplus stock, then ensure you take time to classify it.

Avoid complicating classes

When categorizing inventory items into classes it is easy to make it complex. Avoid this to ensure you can analyze with ease. When you place items into classes you can base in how quickly they move. The fastest-moving items should be in class A, then the next fastest moving items in class B, and so on.

Base service levels on class

After you categorize the items into classes, you want to base their service levels on the class. That is, instead of spending equal time reviewing every class, more time will be spent on class A items as opposed to class C items where you would spend the least amount of time.

Register damage and loss

Business owners do not often count their inventory that is in transit. Avoid doing this and track how much damage and loss is taking place when your inventory is moving. Make sure you record this and account for this in the costs. You want to also record the time taken to receive inventory.

Reclassify when necessary

It is best if you remain flexible when you are classifying items. Sometimes, the market changes can force you to change your classification and you should be prepared for this. Other factors include a change in the purchase, a shift to interest in another product, and so on.

Use a software tool to plan

A software solution can help you better manage your inventory and cut costs. Sometimes costs can slip through the cracks and you may not include them in your calculations. To avoid such problems, ensure that you use an accounting software solution to track expenses daily for best results.

TallyPrime for inventory management

When you require inventory software, think TallyPrime. This business management software takes care of your accounting and inventory needs and is a must-have for MSMEs that want to turn their vision into reality. It comes with inventory management that allows you to manage your inventory in multiple warehouses. You can segregate your product lines with ease, use the appropriate units of measure, set reorder levels, and much more. TallyPrime comes with a range of other helpful features such as payroll processing, taxation, invoicing, and reporting.

Read More:

• How to become more efficient in Inventory Management
• What is Inventory Carrying Cost & How to Calculate it?