ABC Inventory Analysis: Tips for Inventory Management

Last updated on May 17th, 2022 at 04:44 pm

If you’re in this business, you know that optimizing and managing inventory is one of the most time-consuming and daunting tasks you have to face. 

But you have to face it, as proper inventory management helps you avoid running out of products and maintain optimum stock levels. 

One popular technique used to manage inventory and optimize product availability is ABC inventory analysis. Keep reading as we discuss what ABC inventory analysis means and how it supports inventory management. 

What Is ABC Inventory Analysis or ABC Classification?

ABC inventory analysis, also called ABC classification, is an essential part of product management. It’s a method used to group inventory into three distinct categories. The categories are created based on revenue generation data.

With proper ABC analysis, you can identify essential products in your warehouse to prioritize inventory management based on value. This method is based on the Pareto Principle.

The Pareto Principle was discovered by Italian economist Vilfredo Pareto, who believed that optimum economic growth occurs as a result of a small part of the economy. This principle is commonly used to illustrate the idea that not all things are equal, and the minority owns the majority. It’s also known as the 80/20 rule: 80% of consequences come from 20% of the causes.

Based on this rule, you can identify the 20% of products that deliver 80% of the value. 

ABC Analysis Categories

According to ABC Analysis principles, all products can’t have similar or equal value. Therefore, you can break down products into three categories: 

Category A

Category A products have the highest value. This is the smallest category with only a few products.

Category B

Category B products are mid-level items that have slightly higher value, so they are less tightly controlled. These products are bigger in terms of volume but of less utility than the products in Category A. 

Category C

Category C products are more general. This group contains the largest volume of products that generate the least amount of business revenue—they have less value.

Most businesses have a few “A” items, a slightly bigger group of “B” products, and a large selection of “C” products, which defines the majority of items. 

When applying the Pareto Principle, Category A consists of 20% of your total stock, generating 80% of your revenue. The products in this category demand consistent, hands-on control. Items in Category B consist of approximately 30% of your catalog and 15% of your revenue. 

Category C controls almost 50% of your stock but only leads to roughly 5% of total revenue. When calculating inventory in Category C, stock managers can relax a bit.

Those who manage inventory are always looking for ways to achieve greater efficiency or improve pricing and quality. They may use the ABC analysis technique in light of that goal. By using ABC analysis, they can focus most of their time on Category A inventory and spend fewer resources on Category B and C products. 

For example, you might use ABC analysis to first audit the purchase orders of your highest value items (Category A) since these provide your company with the most revenue.

Why Should Your Team Use ABC Analysis?

It’s easier to control working capital costs when implementing ABC analysis for inventory management. 

The information you can glean from this technique reduces obsolete inventory, which boosts your inventory turnover rate—how often you replace products after selling out of them. You can reap a long list of benefits from using ABC analysis in your inventory management processes, including:

Advanced Inventory Forecasting

You can increase sales forecasting accuracy when monitoring and collecting data about products with high customer demand. Then, you can use this information to set inventory levels and prices and increase overall revenue.

Pricing Optimization

When you can identify a surge in sales for a specific product, it’s easy to justify a price increase and improve profitability. 

Improved Inventory Optimization

ABC analysis identities any products that are in demand. Then, you can use valuable warehouse space to stock in-demand products and maintain lower inventory levels for Category B and C items.

Higher-Quality Customer Service

The level of customer service you provide for each product depends on many factors, including item cost, profit margins, and quantity sold. When you can determine the most profitable items, you can offer higher quality service for those products. 

Informed Supplier Negotiations

It makes more sense to spend time negotiating with the suppliers who supply Category A items, as these items generate 70 to 80% of your revenue. If you can’t get the supplier to agree to lower costs, you can try negotiating down payment terms, free shipping, post-purchase services, or other cost savings.

Improved Product Life Cycle Management

You can’t accurately forecast demand and stocking inventory levels without insights into where a product is in its life cycle, whether in launch, growth, maturity, or decline.

Appropriate Stock Turnover Rate

You can maintain the stock turnover rate at appropriate levels through methodical inventory control and data capture using ABC analysis.

More Control Over High-Cost Items

Your Category A products are closely tied to your success. You should prioritize maintaining healthy stock levels and monitoring demand, so you always have enough of these crucial products on hand.

Simplified Supply Chain Management

You can implement ABC analysis to determine whether it’s time to shift to a single supplier or consolidate sources to simplify operations and reduce carrying costs.

How to Implement ABC Analysis

If you want to perform an ABC analysis, you must identify your objective. Once you’ve done so, collect the necessary product information to categorize your product offering

After your products are in categories, closely track and make informed decisions based on your new data. 

Here’s a short step-by-step guide to performing ABC analysis:

  1. Identify Your Objective: ABC analysis will help you meet one of two objectives: raise cash flow or lower procurement costs by optimizing inventory levels of specific products based on production or customer demand. 
  2. Collect Your Data: You’ll want to collect the annual spend on each product. If it’s easy to calculate, collect the weighted cost, including ordering and carrying cost data and gross profit margin.
  3. Sort from Highest to Lowest Impact: Use ABC analysis to rank each product’s order by cost from decreasing order of impact. 
  4. Calculate Each Product’s Sales Impact: For each product, calculate its impact on sales. Do this as a percentage by dividing the annual item cost by the aggregated total of all items spent. You’ll use this number (a percentage) to compare items on your list.

% Impact = (annual item cost) / (aggregated total of all items spent) x 100

  1. Sort Items into Buy Categories: Once you define the categories, work on vendor consolidation, contract negotiation, implementing e-procurement, or shifting strategic sourcing methodology, You could end up with significant savings by making changes in these areas. You may also be able to ensure stock availability of Category A items. Instead of being strict about the 80/20 rule, you should take a holistic approach.
  2. Analyze Categories: Once you’ve defined categories and strategic cost management action items, plan to perform regular reviews to monitor whether your decisions have proven successful.

How to Utilize ABC Inventory Management for Your Business

You should first assess whether ABC analysis would be effective for your business before implementing the strategy. You can easily avoid dangerous assumptions by asking the right questions. 

And if you decide to move forward with ABC analysis, prepare as much as possible for a smoother transition. 

Consider asking yourself the following questions:

  • Are the right processes and systems in place for the effective implementation of the ABC inventory analysis method?
  • Is demand and cost information available for products by demand?
  • Have you assessed the potential change impacts of implementing ABC analysis?
  • Have you evaluated the benefits of implementing and operating using specific, measurable, achievable, relevant, and time-bound (SMART) goals? Do these benefits outweigh potential risks?
  • Do you have specific KPIs related to cost savings that you can track and measure?
  • Is your implementation timeline realistic?

Make the Most of ABC Inventory Analysis Data with Flxpoint

ABC inventory analysis has become a staple tool for inventory managers. Categorizing inventory in this way is a great way to streamline inventory management processes. 

With the proper methods in place, you can easily absolve any concerns related to maintaining inventory and maximizing the value of your products.

Flxpoint can help you maintain ideal stock levels and avoid stock-outs and overstocks by providing real-time inventory visibility. Find out how else Flxpoint can streamline your ecommerce inventory management processes by talking with an expert today.

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