ABC analysis

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ABC analysis is a method used in inventory management that ranks products from most to least valuable. Using demand, cost, and risk data, ABC ranks things, and inventory managers categorize them into distinct groups. This is useful for CEOs in determining which offerings are most important to the company's bottom line.

  • Class A items are the most valuable stock-keeping units (SKUs) because of their high sales volume or high profitability;
  • Class B things are the next most valuable;
  • Class C items are the least valuable.

It's possible that some businesses will choose a system that does not limit the categorization of their goods to the three categories mentioned above (A-F, for example)[1]. Though similar, ABC analysis in cost accounting, also known as activity-based costing, is not the same as its inventory management counterpart. Activity-based costing is used by accountants in the industrial sector to allocate indirect or overhead expenses, such as utilities or salaries, to specific outputs.

Use of ABC Method

According to the Pareto Principle, 80% of effects are typically generated by merely 20% of inputs into a system. ABC analysis, which is based on Pareto's 80/20 rule, pinpoints the 20% of products responsible for delivering 80% of the total value. For this reason, most companies carry only a handful of products in the "A" category, a somewhat larger number of products in the "B" category, and a huge number of products in the "C" category, which encompasses the vast majority of products. It is possible that the Pareto Principle is not always correct [2]. However, studies have shown that the distribution of valued items follows an 80/20 rule. Simply said, ABC analysis pinpoints the sweet spot from where a company generates the most amount of profit with the least amount of work. Managers of stock are continuously on the lookout for ways to boost profits by lowering costs or increasing output per worker. They might use the ABC approach (also known as the "always better control" tactic) to get there. They can use the analysis's findings to prioritize Class A stock and reduce investments in Class B and C shares. In order to maximize revenues, inventory managers will use ABC analysis to focus on verifying orders for Class A items first. Using ABC analysis on inventory helps keep working capital costs in check. Utilizing the study's findings can help businesses reduce stale inventory and boost product sales and replacement cycles.

Benefits of ABC Method

There are numerous benefits to using ABC analysis in stock control. The research isolates the most in-demand products, allowing for more precise inventory management. This allows the corporation to store Class C items at lower levels of stock without having to sacrifice storage space for Class A and B items. If data on high-demand products are closely tracked and collected, accurate sales estimates can be created using the information. The information will help managers determine the optimal stock and pricing strategies, which will ultimately increase revenue. If sales of a product suddenly skyrocket, the company can increase profits by charging more for it. Given that seventy percent to eighty percent of a company's revenue comes from Class A items, it makes sense to strike more favorable terms with their suppliers. If the seller doesn't budge on the price, try to haggle for a discount on the down payment or free shipping instead. An ABC analysis can help you allocate resources effectively and ensure that you’re Class A products are satisfying consumer demand. In the event of a decline in sales, reclassifying the product into a different category can free up resources that can be put toward the newly prioritized Class A items. ABC analysis can help with inventory management, but it is not a silver bullet. The success of an ABC analysis depends on factors such as the organization's specific client demand patterns, classifications, systems, and other concerns.

Limits of ABC Method

ABC analysis isn't perfect for a few reasons.

  1. It puts too much emphasis on the monetary value of inventory
  2. It takes a lot of effort and discipline to implement successfully

Several more challenges include :

  • Parameter Unpredictability:

Based on the findings of an ABC study, managers can reallocate as much as 50% of their stock quarterly or annually. Businesses may not be aware of the shifts until there is a demand issue, at which point it may be too late to make the necessary adjustments without losing quality or irritating customers. Variations in product availability due to things like new product releases or seasonality will not be accounted for by the standard ABC method. For example, consumers may be hesitant to buy a novel product at first because they lack a frame of reference for doing so. Since ABC analysis takes a relatively static stance, it will result in inventory inefficiencies when demand is uncertain or unpredictable. It's possible that managers won't have all the data they need to make informed strategic decisions because of how challenging it is to extract useful information from ABC classes. When doing an ABC analysis, it's crucial to avoid "bikeshedding", the practice of consistently giving more weight to concerns that aren't as significant as others. Due to its accessibility, ABC analysis encourages more participation from staff and more requests for individualized iterations, both of which can be time-consuming and resource-intensive [3].

  • Misunderstanding of Value:

ABC analysis may incorrectly prioritize items based on revenue or usage frequency. For example, having a low-demand novelty item on display can pull in a lot of consumers who end up buying a lot of other items because of the attention they've received. However, in the aviation industry, the importance of a part to passenger safety cannot always be gauged by its market value or its frequency of usage.

Examples of ABC analysis

  • Retail Inventory Management: Retailers use ABC analysis to identify the items that are most important in terms of sales and profitability. They can then focus their attention on these items and ensure that they are kept in sufficient supply to meet customer demand.
  • Manufacturing Inventory Management: Manufacturers use ABC analysis to identify the components that are most important in terms of production costs. This helps them ensure that they are able to produce products in a cost-effective manner while still meeting customer demand.
  • IT Asset Management: IT asset managers use ABC analysis to identify which assets are most important in terms of security and risk management. This helps them focus their efforts on mitigating risks associated with these assets.
  • Human Resource Management: HR managers use ABC analysis to identify which employees are most important in terms of job performance and organizational effectiveness. This helps them ensure that they are able to retain and motivate the most important employees.

Limitations of ABC analysis

ABC analysis can be a useful tool for inventory management, however, it has some limitations. These include:

  • It does not always accurately predict future demand, as there may be other factors that can influence the demand for a product.
  • It does not take into account the cost of carrying the inventory, which can have a significant impact on the profitability of the company.
  • It does not take into account the potential risks associated with carrying the inventory, such as theft or damage.
  • It does not take into account any changes in the marketplace or the competition, which can have an effect on demand for the product.
  • It does not account for any changes in customer preferences or buying patterns, which can also have an effect on demand.
  • It may not always be accurate when it comes to classifying products into the different categories, as there may be multiple ways to categorize them.

Other approaches related to ABC analysis

Inventory management is a complex process and there are various approaches to it. ABC analysis is just one approach which focuses on ranking items from most to least valuable. Other approaches that can be used to manage inventory include:

  • Just-in-Time (JIT) inventory: This is an inventory management approach that involves controlling the flow of materials so that they arrive at the right time and in the right amounts to meet customer demand.
  • Economic Order Quantity (EOQ): This is an inventory management approach that focuses on finding the optimal order quantity that minimizes the costs associated with ordering and holding inventory.
  • Reorder Point (ROP): This is an inventory management approach that determines when an item needs to be reordered to maintain a certain level of inventory.
  • Inventory Turnover: This is an inventory management approach that involves measuring how quickly items are sold and replaced in order to ensure that inventory levels are optimal.

In conclusion, ABC analysis is just one approach to inventory management and there are many other approaches that can be used to ensure that inventory levels are optimal and costs are minimized.

Footnotes

  1. ↑ Aydin, (2013)
  2. ↑ Indrasan, (2018)
  3. ↑ Kvon (2018)


ABC analysis — recommended articles
Stock turn — ABC method — Merchandise inventory — Overproduction — Cycle stock — Abc inventory classification — Maximum stock level — Inventory record — Inventory value — Behind schedule

References

Author: Noé STEPHAN

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