November 30, 2020 Growing & Complex Businesses en_US Learn how you can use ABC Analysis to more efficiently manage your inventory. Read the complete guide from QuickBooks. What is ABC analysis and how can you use it in inventory management?
Growing & Complex Businesses

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

By Dominic Vaiana November 30, 2020

ABC (Always Better Control) analysis is one of the most commonly used methods of inventory management. 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 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.

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.

Inventory categorization 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 optimization, increasing prices, and forecasting demand.

The Pareto Principle & power laws

One day while tending his garden, an Italian economist named Vilfredo Pareto had an interesting observation: 80% of his peas came from only 20%of the pods in his garden.

Over time, he noticed this ratio applied to other areas of life. Most significantly, in 1901, he found 80% of land in Italy was owned by 20% of the population. From one innocent observation, Pareto changed how economics are studied and how we understand the distribution of the world’s resources.

Today this observation is known as the Pareto 80/20 Principle, where 80% of the outputs are caused by 20% of the inputs. There are plenty of 80/20 rule examples, like Microsoft once reporting that 80% of crashes in Windows were caused by 20% of their software bugs. Or that 100 companies are responsible for 71% of global emissions. We can find examples of the Pareto Principle in all facets of life—even in the profits from your business.

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 prioritize and sort specific inventory over others. ABC analysis brings simplicity to inventory analysis by putting all of your inventory 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 minimizes 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 channeling your resources towards high-priority inventory, you can rest assured you’re putting the odds of success in your favor.

3. 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.

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 analyze 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 that have 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.

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. 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 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 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.

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 customize your cycle counting process, which optimizes 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 labor since you only count inventory categorized by class. Otherwise, you’re stuck counting all inventory items at the same time intervals.

Final thoughts

The Pareto 80/20 Principle has a timeless application to so many parts of modern life. It’s no wonder it’s a useful heuristic for growing businesses today. Managing inventory efficiently in today’s always-on business environment can feel overwhelming, especially if you don’t have the right software to keep up. With the ability to analyze your most valuable inventory with a few clicks, you can spend more time focusing on delivering for your customers.

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Dominic Vaiana is a writer and bibliophile based in St. Louis. In addition to writing for QuickBooks, Dominic has developed content and campaigns for global brands such as Mastercard, GoDaddy, and InVision. Read more