What is ABC analysis?
ABC analysis (ABC Classification) is an approach for classifying and controlling inventory items. The raking depends on their consumption value throughout materials and distribution management. ABC analysis classifies a wide range of inventory items such as raw materials, components, parts, manufactured end products and unfinished goods.
ABC analysis is based on the Pareto Principle, you may be familiar with it as the 80/20 rule. The main idea of this Pareto principle is that most economic productivity comes from only a small part of the economy. The principle underlines the unequal relationship between input.
ABC analysis divides an organization’s on-hand inventory into three classes based upon their value. This inventory categorization method divides items into A, B and C categories. A is the category of the most valuable items, with B and C ranking next. The main goal of this analysis is to ensure the manager focuses the attention on the critical few A-items rather than many trivial C-items. Inventory optimization is crucial in keeping the supply chain costs under control.
Category A contains the most valuable products (or customers) of a company. These make up for the biggest percentage of contribution in your profit. These are the items with the highest annual consumption value. According to the 80/20 rule these are the items that produce in greatest output with a small input. If managed efficiently, this category offers the greatest potential to reduce costs per unit.
Category B includes the middle of the road-tiers. This category contains items that have a lot of potential, but don’t reach top priority regardless. With that in might, certain items may turn into category A items with some effort.
Category C includes hundreds of small transactions that altogether contribute to generating income. However, these items don’t make individual contributions. They may be essential for profit but don’t contribute much value to the company on their own.
Why use this analysis? What benefits can it bring?
ABC analysis of inventory has many benefits. Its main goal is to improve your ability to understand large and complex data by breaking it into segments and prioritizing. Any data is easier to analyze if it is broken down into segments. This brings out specific issues within segments and helps to prioritize among different segments accurately. With a clear picture in mind, it is much easier to come up with a plan of action, without wasting much of the company’s resources.
ABC analysis is extensively used in supply chain management and inventory systems. This is one of the best ways to decrease working capital and carrying costs by analyzing the inventory in depth. If the levels of inventory are not regulated accordingly, you might always have either too much or too little stock in your warehouses. This could lead to a number of issues in the future. Performing an ABC analysis helps to identify which items should be in stock to satisfy the customer demand with the least additional costs for the company. With this in mind, you can see that ABC analysis offers the following two main benefits:
- Better control over high-value inventory, which results in minimized costs and losses, and
- Efficient use of stock management resources, which helps to organize the production or re-sale more efficiently.
How to interpret the analysis data?
Of course, conducting an ABC analysis of inventory won’t be of any use, unless you interpret the gathered data properly. Here are a couple of tips concerning your findings to actually make savings based on the results of the ABC calculations. Once you’ve classified the inventory items into three categories, have a closer look at your final data. Review how the inventory in each category is managed. Policies based on ABC analysis might include investing more resources in certain categories compared to others. As a rule of thumb, not all categories should be treated the same, otherwise, it would make no sense to categorize items in the first place.
No differentiation among categories would lead to inefficient and needlessly expensive inventory management. This is why you should adapt your inventory policies to each category according to the data collected by the ABC analysis. For instance, some items of value, such as A-category items, could require more time for discussion and negotiation. This could get you the best quality to price ratio. As for items of lower importance, such as C-category items, you may not need excessive and timely discussions.
Same goes for purchase and re-stocking frequency. Some high demand and high value A-category items may need restocking more often than items from C category with much lower demand. The key here is to make sure you’re allocating most of the attention to those items that have the highest conceivable savings. This is one of the main reasons to incorporate ABC analysis: to save more.
The second important factor you need to pay attention to when going through the data are indicators of potential. Have a closer look at the items in each category. Are there any items that have the potential to have a higher value or a higher demand, that you should move to a higher category? This might be revenue that you’re leaving on the table.
On the other hand, you should also look out for items in the highest-ranked category (A) to which you may be allocating too much attention or credit. Some of these items might not exactly be bringing as much value to your business as you would think. If so, you should consider to filter these out the category and move them accordingly. You should also consider inputting the extra resources and time wasted on such category A items on other items. These could be category B or C items, which have big potential. Perhaps they could transform into category A items in terms of their value with a little more input or minor adjustments.
What are the Challenges of ABC Analysis?
The main problem with policies based on ABC analysis is that they are not compliant with GAAP (Generally Accepted Accounting Principles) requirements. It’s a common set of accounting standards, principles, procedures and rules used by companies for complying financial statements. ABC calculations are not compliant to GAAP due to several reasons.
One of the major reasons is that ABC systems conflict with GAAP when it comes to assigning manufacturing costs to products. Under the ABC system, not all manufacturing costs are assigned to products, unlike GAAP. The logic behind this approach is that expenses such as rent, security, heating, and other organization sustaining costs will be incurred regardless of production levels. So, ABC systems do not assign such costs to specific products. If a certain cost does not depend on the production volume, then such cost is not really relevant to decision-making. From the managerial perspective this approach may make sense, nonetheless, it is still considered a violation of GAAP.
Another reason why ABC systems are not compatible with GAAP, is the exact opposite of the first one. Under ABC systems some specific non-manufacturing costs may be assigned to a product, which is not allowed under GAAP. The logic behind this is the same. If a cost is relevant to the product, it should be included in the product cost, regardless of the fact that these could be non-manufacturing costs.
As a result, since ABC system conflicts with GAAP, an additional costing system will be required besides the ABC method to comply with GAAP.
At some point supply chain managers will face another problem with ABC analysis. It might be challenging to decide in which category to fit an item in. Due to the rise of e-commerce and social media trends may dictate a sudden spike in demand for some items. Such items could initially seem like outliers from a lower category and be unpredictable. When the demand of such items raises overnight, the value raises with it. This means that the item will have to be moved to a higher category in the ABC system. So, supply chain managers would have two options. First one is to constantly monitor and update the classification. The second one would be to try predicting such often unpredictable demand spikes ahead of time, before even categorizing an item.
Another important issue that partially results from the previous two, is that the ABC system will require more resources to maintain, unlike traditional costing systems. Due to their high value and importance class A items must be analyzed constantly to determine whether the category still consists of high-priority items at any given time. Any items that no longer hold high value and are not in demand have to be moved to another category. Constant updates and monitoring will require more data collection and measurement. This can be quite costly.
Despite some disadvantages, ABC analysis of inventory is a great way to gather and use relevant data. This data could be useful in reducing excess costs and generating more profits. For best results, however, it is also important to constantly monitor the categories. You must also update them according to changing demand levels in the market and organize your inventory management wisely by tailoring your approach to each category.