What is ABC Analysis in Inventory Control?

What is ABC Analysis in Inventory Control?

Rhema Hans
Rhema Hans
Table of Contents
Table of Contents

Recent reports suggest that approximately $1.1 trillion cash, equal to 7% of the U.S. GDP, gets tied up in inventory. This means, more than the money that you could earn on your sales, is in reality stuck in your warehouse. Shocking right?

The majority of the companies today, face the problem of managing their inventory right. After all, it is difficult to maintain the optimum level of inventory, when you are dealing with a diversity of customer demands. However, with a good inventory control system, you will be able to manage your stocks efficiently.

ABC Analysis

Inventory control assists businesses to maintain ideal stock levels. It tops the priority list of many industries such as the E-commerce industry, manufacturing, logistics, retail, and other businesses that deal with inventories. There are various methods of inventory control, and ABC analysis is one such method.

What is ABC analysis?

What’s so great about ABC analysis?

We are going to answer these two major questions today in this article.

By the end of this article, you would have understood:

  1. What ABC analysis in inventory control is
  2. How to conduct ABC analysis in 5 easy steps
  3. Major benefits of ABC analysis
  4. Different uses of ABC analysis

Now, let’s begin by understanding what ABC analysis is.

What is ABC analysis?

ABC analysis also referred to as ABC Classification, is a vital part of Inventory Management. It allows business owners to distinguish the products in their stock and focus on managing them based on their worth. The main objective of ABC analysis is to make maximum out of minimum investment without wasting any resources or inventory.

ABC analysis is an inventory classification strategy that categorizes the stocks into three categories, A, B, and C, based on their revenue.

Now let us find out what these three categories are.

3 Categories of ABC Analysis

The ABC analysis considers that all the goods cannot have equal value in the market. They are found in three different categories:

ABC analysis

Segment A: Products included in category A are the most essential goods with the highest value. Segment A goods consist of approximately 20% of the total products with 80% of revenue generation for your business.   It is considered as a small category with minimal goods, but maximum revenue.

Segment B: Products included in category B have a slightly higher value than segment B. It approximately regulates 30% of goods with 15% revenue generation. Not to mention, the goods included in this category are more in number but less in utility.

Segment C: Products included in category C are more in numbers but least valuable when it comes to generating revenue. As compared to category A & B, segment C has the maximum share of 50% of the stock, generating just 5% revenue.

Segments of ABC

To sum it up, A signifies the most important goods, B indicates moderately necessary goods, and C indicates the least essential inventory.

Now that you have understood the basis of segregating these goods, let us learn how to conduct an ABC analysis.

Conduct ABC analysis in 5 Steps

You can perform ABC calculations on individual products, groups of inventory, and a wide range of inventory and you can calculate in just 5 easy steps. Take a look.

Step 1: Use the formula mentioned below to calculate the annual consumption value of each product.

Annual number of units sold (per item) x cost per unit

Step 2: Enlist all the products in descending order based on their annual consumption value

Step 3: Total the number of units sold and the annual consumption value of the products.

Step 4: Calculate the cumulative percentage of the goods sold and the cumulative percentage of the annual consumption values.

Step 5: Divide the data into three categories. The split of the ABC categories will be unique to your company but approximately, 80%, 15%, & 5%.

Now that you have learned how to calculate the ABC analysis, let us look at the perks or benefits of ABC analysis.

Benefits of ABC analysis

Most of the organizations have a huge amount of stock-keeping units (SKUs), yet they have not been able to prosper or upscale their business significantly. There are many other challenges in inventory management that businesses have to handle. Challenges may include lack of information on stocks, a weak management process, difficulty in managing employees, space, and so on.

ABC analysis is a solution to this problem.  It can assist companies to streamline and optimize their inventory management. Let’s find out how.

Analyze Customer Demand for a Product

Every product goes through four different stages after production- dispatch, growth, development, and declination later. Once the product hits it actual worth, its demand in the market starts sinking after a point. You can call it a life expectancy rate of a product. And the life expectancy of any product depends upon the client's requests.

ABC analysis helps companies identify customer demands. Often companies assume the demand for the goods and end up stocking up extras. To rule that dark room out of your business, ABC analysis makes sure that you know what your customer wants.

As a result of this,  you will be able to manage your inventory efficiently and effectively. You will only order the products that your customers want, neither more than the requirement nor less than demand.

Note: A point to remember is if the market observes a sudden rise in demand for a particular product, the declination of that specific product gets further delayed.

Enables Negotiations with Suppliers

ABC analysis proves helpful in getting a fair deal on a product from a supplier. Let's see how.

For instance, if you are negotiating with a supplier for an A category product, you know you have to invest maximum since it generates the most revenue for your company. If the supplier is reluctant to make you the right offer or accept your offer, you can interest them with any extra benefits from your end. Maybe, a contract of sorts that you will take the next batch of goods from the same supplier.

As a result, you will not only crack a good deal as per your needs, you will additionally save more on A category products, procuring more benefits.

Improvement in Customer Service

When you don’t know the accurate level of inventory that you should order, you end up stocking up on goods that might not even be beneficial to you. You stock up on unnecessary goods instead of stocking up on goods that your customers may want.

With the use of ABC analysis, you will know exactly what your customers are looking for or what they want. This as a result will help you satisfy your customer demands and extend your business. Not to mention, this will also cut down on the unnecessary from your budget and you will focus, invest only on the goods that earn you profit.

Along with that, you will also reduce inventory costs that you could be wasting on goods that do not interest your customer.

Manufacturing of Goods

ABC analysis enables manufacturers to improve their cycle of renewal of stocks. It allows them to manufacture goods based on their annual cost and not produce goods randomly. What often happens, as we have also discussed before, we often assume demand.

Manufacturing Of Goods

This assumption leads to production of goods that are not required, and then stocking them up in the warehouse where they sit for the longest.  As a result of this you find yourself facing your worst nightmares as a business owner, your goods are damaged towards sitting in the warehouse.

With ABC analysis, manufacturer will be able to understand the worth of their products and only produce those goods high in demand and for those with low in demand, the quantity will be more controlled.

Supply Chain Management & Warehouse Management

The inventory control technique of ABC analysis is used to improve the stock count cycle in a company. For example, the goods belonging to Category A of the ABC analysis are counted quarterly, goods in category B are counted bi-annually, category C products are calculated only once a year. In this way, you don't waste too much on checking your inventory or no longer completely ignore your inventory status.

When you have A category products that earn you the most profit you want to make sure that they are always in stock if not in abundance, by doing frequent checks.

Often when you don't know what your products worth or assume their worth you refuse to focus on the state/status of your warehouse in terms of stocks. This may lead to going out of stock or wastage of stocks.

These were some of the compelling benefits of ABC analysis you should not be missing out as a business owner.

Now that you have understood almost everything you need to know about ABC analysis, let us tell the ways in which you an use it in your business.

Using ABC Analysis in Different Ways

Companies generally use ABC analysis to identify their maximum revenue-generating products and the most important clients who buy them. But it is also use to identify their target audience or understand their customer base.

Similar to how goods are categorized as A, B, & C, depending on their worth in the market, clients are classified in the same way based on whether they buy category A products, B or C. On the basis of this categorization, the businesses try to engage with the customers.

Another application of ABC analysis is in the pharmacies, let us find out how.

ABC Analysis in Pharmacy

Let’s take the example of ABC inventory analysis in healthcare organizations, e.g. a pharmacy.

Pharmacy Inventory Analysis

Since, one-third of a hospital budget is spent on buying materials and supplies, especially medicines, it is necessary to have a strong inventory management system.

A case study conducted by SAC college of Pharmacy shows that introducing inventory control measures for managing expensive medicines in a 1500 bed, government hospital can bring about savings of up to 20%.

The pharmacy first arranged the expenditure of specific medicines in descending order, and then the cumulative cost of all the items was calculated. Followed by this, both cumulative percentages of expenditure and the number of items were calculated.

Lastly, based on the cumulative cost percentage of the inventory, the list was then divided into three categories, A (70%), B (20%), and C (10%).

The table reflects that 10% of medicines cost about 70% of the annual budget, 20% of inventory costs 20% of the financial budget, and the remaining 70% of inventory reports for just 10% of the budget.

Lastly, based on the cumulative cost percentage of the inventory, the list was then divided into three categories, A (70%), B (20%), and C (10%).

Item

  Items

 (%)

Money value 

(%)

A

10

70

B

20

20

C

70

10


With the use of ABC analysis, the pharmacy was benefited in several ways:

  • The pharmacy got a more detailed and accurate idea of the demand and expense of the medicines.
  • ABC analysis helped the pharmacy to identify the medicines that require stringent control for optimal use of the budget allocated to them.
  • It helped them do away with the overhead costs.

This is how you can use ABC analysis in your pharmacy and control your inventory for maximum output with minimal investment.

Along with the health care sectors and retail businesses, banks, and many other industries are likely to adopt ABC analysis in their business within the next few years.

Not to forget, apart from ABC analysis, you might want to consider other popular methods of inventory control- Economic Order Quantity (EOQ), Just in Time (JIT), and Fast Slow and Non-moving (FSN).

How can Deskera help your Inventory and Business?

As a business owner, you can invest in accounting softwares that can help you keep track of your journal entries, balance sheet, inventory and production costs.A successful business needs an efficient financing process that meets its specific needs.

Deskera Books is an online accounting software that your business can use to automate the process of journal entry creation and save time. The double-entry record will be auto-populated for each sale and purchase business transaction in debit and credit terms. Deskera has the transaction data consolidate into each ledger account. Their values will automatically flow to respective financial reports.

You can have access to Deskera's ready-made Profit and Loss Statement, Balance Sheet, and other financial reports in an instant.

Deskera can also help with your inventory management,  customer relationship management, HR, attendance and payroll management software. Deskera can help you generate payroll and payslips in minutes with Deskera People. Your employees can view their payslips, apply for time off, and file their claims and expenses online.

Deskera Books
Deskera Books
Deskera People

With Deksera CRM you can manage contact and deal management, sales pipelines, email campaigns, customer support, etc. You can manage both sales and support from one single platform. You can generate leads for your business by creating email campaigns and view performance with detailed analytics on open rates and click-through rates (CTR).

www.deskera.com
www.deskera.com

Deskera is an all-in-one software that can overall help with your business to bring in more leads, manage customers and generate more revenue.

Deskera All-In-One Platform
Deskera All-In-One Platform

Conclusion

ABC Classification is no doubt a go-to for any business since it offers a plethora of benefits. However, one of its major limitations is that it is time-consuming and effortful as all your goods have to be divided into three categories based on their value.

What you can do to resolve this is to adopt inventory optimization software that can automate and streamline the entire process.

If you are interested in investing in a feasible inventory management software, then Deskera might interest you. It helps you to organize your inventory, all in one place. Easily classify them in the A, B, C, category.

So, if you want to streamline your inventory management system, Deskera is a must-have.

Key Takeaways:

  • ABC analysis is an inventory classification strategy that categorizes the goods into three categories, A, B, and C, based on their revenue.
  • ‘A’ in ABC analysis signifies the most important goods, ‘B’ indicates moderately necessary goods, and ‘C’ indicates the least essential inventory.
  • The split of the ABC categories will be unique to your company but approximately, 80%, 15%, & 5%.
  • ABC analysis helps companies identify customer demands and stock up goods accordingly.  This, as a result, reduces wastage of goods & capital both.
  • It allows you to get affordable and best deals from suppliers.
  • ABC analysis enables you to keep up with customer demands, satisfy your customers by always having what they want.
  • With the help of ABC analysis, the manufacturing of goods is only done on the basis of customer demands. This helps in saving more capital and resources too.
  • Counting of specific goods is done more frequently depending on the category that they belong to.  As a result, you neither have goods in overabundance nor do you go out of stock.
  • Since medicines come under essential goods, under these too there are medicines that should always remain in stock. With ABC analysis you can easily classify what these medicines are
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