What is ABC analysis and how can you use it in inventory management?

ABC (Always Better Control) analysis is one of the most commonly used inventory management methods. ABC analysis groups items into three categories (A, B, and C) based on their level of value within a business.

Classifying inventory with ABC analysis helps businesses prioritise their inventory, optimise operations, and make clear decisions. Coming up, we’ll explore ABC analysis in-depth, explain how to use it, and help you decide if it’s right for your business.

Why use ABC analysis for inventory management?

As the name implies, ABC analysis sorts inventory into three main buckets:

• A items: This is your inventory with the highest annual consumption value. It should be your highest priority and rarely, if ever, a stockout.
• B items: Inventory that sells regularly but not nearly as much as A items. Often inventory that costs more to hold than A items.
• C items: This is the rest of your inventory that doesn’t sell much, has the lowest inventory value, and makes up the bulk of your inventory cost.

Learn how to calculate your inventory cost.

Inventory categorisation is essential with physical products because it protects your profit margins and prevents write-offs and losses for spoiled inventory. It is also the first step in reducing obsolete inventory, supply chain optimisation, increasing prices, and forecasting demand.

The Pareto Principle & ABC analysis

The Pareto principle, also known as the 80/20 rule, states that 80% of outputs are caused by 20% of the inputs. 

The eponymous principle was discovered by Italian economist Vilfredo Pareto, who observed that 80% of the peas in his garden came from only 20% of the pods he planted. More significantly, he noticed a similar ratio when he realised 80% of land in Italy was owned by 20% of the population. 

Since then, the Pareto principle has changed how economics is studied and how we understand the distribution of the world’s resources.

ABC inventory analysis is based on the Pareto Principle, meaning it’s often the case that about 20% of a company’s inventory accounts for 80% of its value. This insight enables leaders to make more operationally informed decisions.

The way Pareto’s Principle factors into ABC analysis is how it is used to prioritise and sort specific inventory over others. ABC analysis brings simplicity to inventory analysis by putting all of your stock into three buckets, enabling you to make more strategic decisions.

What are the benefits of ABC analysis?

Let’s look at three ways ABC analysis can improve your business’ bottom line:

1. More accurate demand forecasting

Using ABC analysis, inventory planners can predict the demand for specific products and manage their inventory accordingly. This insight minimises carrying costs for obsolete items, thus improving your supply chain management.

2. Better control of high-value inventory

The success of many businesses hinges on A-class inventory. ABC analysis enables you to identify those items in real-time, monitor demand for them, and ensure they’re never out of stock. By channelling your resources towards high-priority inventory, you can rest assured you’re putting the odds of success in your favour.

3. Strategic pricing

ABC analysis can optimise your pricing strategy for products that bring the most value to your business. Once you understand which products are in high demand, you can increase their price, which can significantly impact profits.

What are the shortcomings of ABC analysis?

While ABC analysis is an essential tool for many businesses, there are a couple of drawbacks to be aware of:

Regular oversight required

To get the full benefits of ABC analysis, you must analyse inventory regularly to ensure A-inventory still consists of high-priority items. Otherwise, you risk squandering resources on lower-value items. Data collection and analysis can put a strain on businesses that don’t have proper accounting software.

Lacks precision

An ABC analysis can overvalue frequently purchased items that get people in the door over luxury goods with a lower purchase frequency but higher profit margin. ABC analysis can also miss swings in demand for seasonal items or new items that haven’t accrued much sales volume data.

How to use ABC analysis with inventory

To perform an ABC analysis for your business, follow these three steps:

1. Classify your inventory

The way you classify your inventory depends on what kind of business you’re running and your company’s objectives. Your classifications should align with the type of inventory you hold and how your business is run. Any metric you use should measure your inventory’s consumption value for a given period. Standard metrics are total sales, gross margin, purchasing costs, and holding costs. After you calculate the percentages for each item, place them in your A, B, and C categories.

2. Create rules for inventory classes

For your different inventory categories (A, B, C), create a set of rules or actions for how your classifications should function. For example, class A inventory should never have a stock out or have a certain turnover threshold. Then for C-class items, it’s fine if you have stockouts, but you don’t want to write off any spoiled inventory. You could rely on an inventory management solution to gain rapid insight into how your team performs relative to these standards.

3. Monitor and look for opportunities to change classes

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.

Once all inventory has been reviewed and categorised, the next step is to implement your ABC analysis. The following section shares some recommended ways to make the most of this approach in your business.

Best practices for implementing ABC analysis

ABC analysis works best when applied consistently and reviewed regularly. Here are some best practices when implementing ABC analysis in your business:

Keep inventory classifications simple

With the goal of streamlining your inventory management, the classifications of your ABC analysis are best kept simple. It should be easy for your teams to know which products belong to specific classes immediately. For example, common classification methods are according to the product's price or sales frequency.

Set labour levels according to classification

Each classification should be assigned its labour level or the number of hours dedicated to working on the particular inventory class. Naturally, the more value or impact the class has on the business, the higher labour levels should be allotted to the classification. 

Review each class individually

Every classification should be measured against its own rules set by the initial ABC analysis. This includes a different set of KPIs, performance reviews, and approach to reordering or selling any overstock.

Revisit original classifications

The initial ABC analysis took into account the types of products and business status at that point. As inventory and markets change, it’s important to revisit the existing classifications and reclassify, if necessary. Consider consumer trends, new industry competitors, and changes in sales per class and product. 

Utilise software tools and data

Inventory software can help track all the changes in product turnover and sales. With an established set of rules and actions, you can easily use an inventory management system to automatically track and create reports to highlight any key areas of improvement.

ABC analysis example

Let’s say you run an e-commerce women’s accessories boutique. You just had a good quarter, and you finally have the time to analyse inventory. As you can see in the chart below, earrings are your most popular items, shoes are almost as popular, but neither are pricey, so they don’t generate much revenue. However, your designer purses make up 70% of your revenue, even though you only sold 13 of them.

It’s clear that purses should be in category A, shoes in category B, and earrings in category C.

Now, what can you do with this analysis? To start, you could spend more time looking for the best designer purses, finding higher-end items to increase sales. You could also negotiate better terms with suppliers or spend money advertising your purse selection. Maybe you want to increase the number of items in your inventory, so your customers have a bigger selection.

How to use ABC analysis for cycle counting

A cycle count is the process of counting specific items within your inventory on scheduled dates. Some companies use cycle counting to create count lists for various sections of their warehouse every month. Still, the frequency can vary depending on how often stock levels fluctuate.

ABC analysis lets you customise your cycle counting process, which optimises inventory control for your unique needs. For example, you might decide that your A items should be counted every month, while B items only need to be counted every quarter.

When ABC analysis is applied to cycle counting, it saves precious time and labour since you only count inventory categorised by class. Otherwise, you’re stuck counting all inventory items at the same time intervals.

Final thoughts

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. 

Using dedicated software can streamline the inventory management process even further. QuickBooks Enterprise offers an inventory management platform to track individual product levels in real-time, collect critical product information, and improve efficiency across all order management.

While every care has been taken to ensure the accuracy of the information presented as at 01 May 2023, Intuit is not providing you with professional advice and we recommend you obtain your own professional advice. Intuit is not liable for your use of the information presented.