What is ABC analysis? How to use it in inventory management

An always better control (ABC) analysis is one of the most commonly used inventory management methods, grouping items into three categories (A, B, and C) based on their level of value within a business.

Classifying inventory with this method helps businesses prioritize their inventory, optimize 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.

How ABC analysis works in inventory management

Pros of ABC Analysis

Cons of ABC analysis

How to calculate ABC analysis in inventory management in 3 steps

ABC analysis best practices

ABC analysis for different industries

Navigate midsize business challenges and opportunities

ABC analysis FAQ

How ABC analysis works in inventory management

The ABC inventory analysis method is based on the Pareto Principle, which states that 80% of outputs are caused by 20% of the inputs. This insight enables leaders to make more operationally informed decisions.

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.

Inventory classifications are essential for physical products because they protect profit margins and prevent write-offs and losses for spoiled inventory. It is also the first step in reducing obsolete inventory, improving supply chain efficiency, increasing prices, and forecasting demand.

Pros of ABC Analysis

ABC inventory analysis can improve your business’s bottom line, but there’s more to it than meets the eye. Here are a few of the key advantages of ABC analysis that you can expect to see when incorporating it into your processes.

More accurate demand forecasting 

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

Better control of high-value inventory

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

Strategic pricing

ABC analysis can optimize 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.

Better business decisions

Using ABC analysis for inventory control allows you to make better business decisions based on your company’s performance. You’re able to analyze and monitor the products that are providing the greatest value for your business, adjust your orders as needed, and meet customer demand more seamlessly. And if products aren’t adding tons of value to your business or increasing your bottom line, you can phase them out to maximize your profits and bring in products that speak to your customers’ needs.

Improved customer service

The products that have the biggest impact on your company’s profits do so for a reason: they’re typically the most in-demand with your customer base. By tracking which products offer the most value to your business, you’ll be better able to make sure they’re always in stock. 

This improves the quality of the customer experience and makes it easy for you and your team to boost your customer service efforts.

Cons of ABC analysis 

Though ABC analysis in inventory management is beneficial, it’s not flawless. These are some of the disadvantages you may encounter when using this method.

Regular oversight required 

To get the full benefits of ABC analysis, you must analyze inventory regularly to ensure that the 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.

Challenging to implement

The ABC analysis method can be tough to implement without an appropriate inventory management software or program. Investing in the right software can be costly, and the time needed to learn how to use the program could take away from your ability to run your business.

Not applicable to every business

ABC product analysis is not something you can implement in every business or in every industry. It’s best for companies with simple inventories and products that can easily be classified into three categories. If you have a more complex inventory or sell services rather than goods, implementing this method may not be beneficial.

Supply issues

Since ABC analysis prioritizes the product(s) that add the greatest value to your business, it may lead to supply issues with other items. If you’re not keeping a close eye on the rest of your inventory and ordering when needed, you risk running out of products that are still valuable even if they contribute less to your bottom line.

How to calculate ABC analysis in inventory management in 3 steps

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. 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.
3. Monitor and look for opportunities to change classes: 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.

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 analyze inventory. 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.

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 vendors 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.

ABC analysis best practices 

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

• Simplify inventory classifications: Make your classifications easy for your team to interpret and understand. They should know immediately which products belong to specific classes.
• Set labor levels according to classification: The more impact a product has on your business, the more hours of labor should be assigned 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 an approach to reordering or selling any overstock.
• Revisit original classifications: 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.
• Utilize 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 for different industries

As mentioned earlier, ABC analysis for inventory management can vary by industry. Here’s what it often looks like in some of the most common industries utilizing this method:

• Manufacturing: ABC analysis can help businesses in the manufacturing industry increase profit margins by identifying the items or products that are responsible for the bulk of their revenue. This helps them adjust labor and resources to boost production of those products first before allocating additional resources to other products.
• Retail: Businesses in the retail sector can use ABC analysis to identify the products that contribute the most to their revenue. This helps businesses target their ordering and promotions to drive sales for those products, thereby increasing revenue in the long run. ABC analysis can also help inform retailers of which products should be included in their safety stock and which can be allowed to dwindle before reordering.
• Automotive: Automotive manufacturers can use ABC analysis to identify the highest priority parts or models. Companies can use this information to adjust labor allocations, improve stock, and reduce out-of-stock problems.

Only a few of the top industries can benefit from implementing ABC analysis into their operations. The system can easily work for other sectors but may require some adjustments to create a method that aligns with each company’s needs.

Navigate midsize business challenges and opportunities

Performing an ABC analysis is an effective way for a business to determine the value of its products. 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.