4 Min. Read

What Is ABC Analysis & Its Importance in Inventory Management

March 22, 2024

If you run a business with a large inventory, you probably know the woes of inventory management. Managing your business’s inventory items can be difficult. Thankfully, there are well-developed best practices for inventory management. One of them is ABC inventory analysis. Using ABC analysis in inventory management can change the way that you do business. Keep reading to find out more!

Here’s What We’ll Cover:

What is ABC Inventory Analysis?

The Benefits of ABC Analysis in Inventory Management

Limitations of the Method

Key Takeaways

What is ABC Inventory Analysis?

ABC analysis is one of many inventory management methods. It’s a method that many business owners swear by. It determines the value of inventory items based on their importance to the business. It ranks them based on demand, inventory costs, and risk data. Then, an inventory manager can group the inventory items into classes based on the collected data.

Classification systems are broken down into an A-B-C ranking method, as the name implies. High importance items, based on either sales volume or profit gains, are in the A-class. Then, the next most important items are put into the B-class. The least important items are placed into the C-class. Some companies will break down their classes even further, like a grading scale from A to F.

ABC Analysis is Related to the Pareto Principle

If you’re unfamiliar with the concept, the Pareto Principle states that most results only come from 20% of efforts. This can be applied to business. When it is applied to the ABC analysis, it means that a business should have a limited number of A-class items. Respectively, the B-class items and C-class items will increase in amount. It also sets up general guidelines for the items.

A-Class: High dollar value, lowest inventory levels, tight control, and high annual consumption value
B-Class: Medium dollar value, medium inventory levels, medium control, medium annual consumption
C-Class: Low dollar value, low inventory levels, basic control, low annual consumption

Keeping this in mind, the Pareto Principle won’t always be accurate. There are exceptions to the rule. It can be observed and identified through review of inventory records. Accurate records should be kept on all of your inventory. However, the more valuable classes of items will have higher accuracy as their control is tighter.

The Benefits of ABC Analysis in Inventory Management

There are a whole host of benefits to using ABC inventory management. The main benefits are the inventory control and information gained by using the method. It can help reduce unnecessary inventory, and boost the inventory turnover rate. Some of the more specific benefits are listed below.

Inventory Optimization

This method allows you to identify products that are in demand, and items that are not. This allows a business to optimize their inventory, keeping high demand products in stock. Lower stock can be kept for items that aren’t in demand.

Better Customer Service

Once A-class items have been determined, you can focus your attention on them. This includes the customer service portion. Valuable customers will be after your items that produce a higher profit margin. As such, you can cater to them specifically.

Control of High-Cost Items

The ABC method allows you to control your high-cost items. This is crucial to running a successful business. The inventory management related to these high-cost items can make or break a business. If too many are bought then funds will exhaust. If not enough are on hand then customers won’t be happy.

More Informed Pricing

If your business is able to identify a high-value item through ABC management, then you may be able to justify a price increase. High-value items tend to be in high demand, and as demand rises, so can prices.

Limitations of the Method

Although ABC analysis is an excellent inventory management technique, it still has its drawbacks. The main drawbacks are listed below.

Limited Pattern Considerations: ABC analysis doesn’t take into account inventory patterns. This includes new products, seasonal items, and special items.
High Resource Consumption: Many employees may take it upon themselves to engage in ABC analysis. This can cause employee resources to be misdirected.
Standardization: ABC analysis requires all items to fit a specific standard. Unfortunately, that’s not how inventory works in real-world scenarios. Not all products are alike enough to be standardized.

Key Takeaways

If you’re looking for a new inventory management method, ABC analysis should be on your list of considerations. It’s an excellent tool for identifying inventory that should be focused on, and implementing control over it. ABC analysis can help your business go much further. If this article helped you, be sure to check out our resource hub for more like it!