Topic 1 Material Analysis

Lesson 1 ABC Analysis

Time Frame Week 2 | 3 hours

Learning Outcomes | At the end of this topic, you should be able to:

1. Define ABC Analysis in inventory management;

2. Describe how ABC Analysis related to Pareto Principle;
3. Identify how ABC Analysis results beneficial to inventory managers.
Materials

• Computer, Pen, and paper

Vocabulary Lists

1. ABC analysis is an inventory management technique that determines the value of inventory
items based on their importance to the business.
Acronyms

1. SKU -Stock Keeping Unit.

Discussion

ABC Analysis in Inventory Management: Benefits & Best Practices

What Is ABC Analysis in Inventory Management?
ABC analysis is an inventory management
technique that determines the value of
inventory items based on their
importance to the business. ABC ranks
items on demand, cost and risk data, and
inventory managers group items into
classes based on those criteria. This helps
business leaders understand which
products or services are most critical to
the financial success of their
organization.
The most important stock keeping units (SKUs), based on either sales volume or profitability, are “Class
A” items, the next-most important are Class B and the least important are Class C. Some companies
may choose a classification system that breaks products into more than just those three groups (A-F,
for example).

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ABC analysis in cost accounting, or activity-based costing, is loosely related but different from ABC
analysis for inventory management. Accountants use activity-based costing in manufacturing to assign
indirect or overhead costs like utilities or salaries to products and services.
How ABC Analysis Relates to the Pareto Principle
The Pareto Principle says that most results come from only 20% of
efforts or causes in any system. Based on Pareto’s 80/20 rule, ABC
analysis identifies the 20% of goods that deliver about 80% of the
value.

Therefore, most businesses have a small number of “A” items, a

slightly larger group of B products and a big group of C goods, a
category that that defines the majority of items.

The Pareto Principle may not always be completely accurate. However, analysis shows that valuable
things do tend to bend toward an 80/20 distribution. ABC analysis identifies the “sweet spot” where
most of a business’s revenue comes from with relatively little effort.
How Is ABC Inventory Analysis Calculated?
Conduct ABC inventory analysis by multiplying the annual sales of a certain item by its cost. The results
tell you which goods are high priority and which yield a low profit, so you know where to focus human
and capital resources.
Use this formula for ABC inventory analysis:
(Annual number of items sold) x (Cost per item) = (Annual usage value per product)
You can use Microsoft Excel to do a basic ABC inventory analysis. List each product or resource in
descending order according to its product usage value. Calculate the total of each item in the aggregate
amount. Determine the values for the A, B and C categories, then assign a group name to each item.
The goods with the highest value then get the manager's closest attention.
How ABC Analysis Simplifies Work for Inventory Managers
Inventory managers are always looking for ways to improve pricing and quality or to achieve greater
efficiencies. In light of that goal, they may use the ABC technique, sometimes called the “always better
control” method. They can use the analysis to focus their time and effort primarily on Class A inventory
and less on B and C class products. For example, inventory managers will use ABC analysis to check the

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purchase orders of the highest value (Class A items) products first, since these generate the most
revenue.

Why Use ABC Analysis?

Using ABC analysis for inventory helps better control working capital costs. The information gained
from the analysis reduces obsolete inventory and can boost the inventory turnover rate, or how often
a business has to replace items after selling through them.

ABC Analysis Benefits

A long list of benefits can result from applying ABC analysis to inventory management, including:

• Increased Inventory Optimization: The analysis identifies the products that are in demand. A
company can then use its precious warehouse space to adequately stock those goods and
maintain lower stock levels for Class B or C items.
• Improved Inventory Forecasting: Monitoring and collecting data about products that have high
customer demand can increase the accuracy of sales forecasting. Managers can use this
information to set inventory levels and prices to increase overall revenue for the company.
• Better Pricing: A surge in sales for a specific item implies demand is increasing and a price
increase may be reasonable, which improves profitability.
• Informed Supplier Negotiations: Since companies earn 70% to 80% of their revenue on Class A
items, it makes sense to negotiate better terms with suppliers for those items. If the supplier
will not agree to lower costs, try negotiating post-purchase services, down payment reductions,
free shipping or other cost savings.
• Strategic Resource Allocation: ABC analysis is a way to continuously evaluate resource
allocation to ensure that Class A items align with customer demand. When demand lowers,
reclassify the item to make better use of personnel, time and space for the new Class A
products.
• Better Customer Service: Service levels depend on many factors, like quantity sold, item cost
and profit margins. Once you determine the most profitable items, offer higher service levels
for those items.
• Better Product Life Cycle Management: Insights into where a product is in its life cycle (launch,
growth, maturity or decline) are critical for forecasting demand and stocking inventory levels
appropriately.
• Control Over High-Cost Items: Class A inventory is closely tied to a company’s success. Prioritize
monitoring demand and maintaining healthy stock levels, so there’s always enough of the key
products on hand.
• Sensible Stock Turnover Rate: Maintain the stock turnover rate at appropriate levels through
methodical inventory control and data capture.
• Reduced Storage Expenses: By carrying the correct proportion of stock based on A, B or C
classes, you can reduce the inventory carrying costs that come with holding excess inventory.
• Simplified Supply Chain Management: Use an ABC analysis of inventory data to determine if
it’s time to consolidate suppliers or shift to a single source to reduce carrying costs and simplify
operations.
ABC Analysis Limitations
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ABC analysis, despite all its benefits for inventory maintenance and management, is not a one-size-fits-
all inventory management solution. Every organization has specific customer demand patterns,
classifications, systems and other issues that affect the usefulness of an ABC analysis.

The disadvantages of ABC analysis stem from two issues: an emphasis on the dollar value of inventory
and the significant amount of time and discipline it takes to apply the method. Here are a few more
challenges:

• Parameter Instability: ABC analysis often results in managers assigning up to 50% of items to a
new category every quarter or year. Often, companies are not aware of the changes until there
is a problem with demand, and the need to reassess may take up valuable time and jeopardize
customer satisfaction.
• Limited Pattern Consideration: The standard ABC method will not account for factors like new
product introductions or product seasonality. For example, a new product may have low sales
volume because it has no buying history. ABC analysis has a somewhat static perspective on
demand and will generate inventory inefficiencies whenever demand is shifting or unclear.
• Low Information Extraction: ABC class information may not provide all the statistical data or
detail needed to make informed, strategic management decisions.
• High Resource Consumption: Giving disproportionate weight to trivial issues is known as bike
shedding, which can be an unfortunate consequence of ABC analysis. Since ABC analysis is easy
to grasp, staff may inject their opinions or request their own variants making ABC analysis a
resource-consuming process rather than a time-saving tool.
• Value Blindness: ABC analysis ascribes product importance based on revenue or frequency of
use, but some items may not hold to this paradigm. For example, a retail display item may
rarely sell but may attract a lot of customers (who will buy other products) based on its novelty.
In aerospace, a specific part for a plane may not be used often and have little market value, but
it may be a fundamental safety function.
• System Incompatibility: ABC inventory analysis conflicts with traditional costing systems and is
out of compliance with generally accepted accounting principles (GAAP) requirements. If you
must run multiple costing systems, labor costs will rise alongside inefficiency.
• Undersupply or Oversupply Issues: One ABC analysis disadvantage is it looks at dollar-based
values, rather than the volume that cycles through inventory, so there is a risk of running out
of Class B or C items. The opposite can occur, too. You may have excess low-class items that
accumulate in inventory if you reorder them without regular reviews.
• Loss Risk: Just because B and C items do not have as high a value as Class A products does not
mean they no value. One of the limitations of ABC analysis is that excess stocks are always in
jeopardy of obsolescence or damage. Therefore, the inventory that habitually goes uncounted
or unmonitored may be subject to theft.
• Mandatory Standardization: The ABC method is only successful if every item is subject to the
standardization of materials, which includes how they are named, stored, and consistently
rated and monitored.
• Arbitrary Categorization: Without preset boundaries or agreed-upon standards for each
category, classifying goods depends on the manager's professional judgment. So this can be a
relatively subjective process.

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 • Business Limitations: ABC analysis is not useful for companies that have an equable annual
consumption value of inventory items by type. For instance, a company that sells the same
version of an item like candy, nails or socks, may not be able to sort stock based on the Pareto
Principle.
• High Resource Consumption: Companies with a significant number of inventory items will have
to hire additional staff or buy special equipment to control inventory using ABC categorization.
How to Perform ABC Analysis
A thorough ABC analysis begins with identifying the objective you’re trying to reach. Once you have
that, collect the necessary information to categorize the items. Once the classes are in place, closely
track and make decisions based on the resulting data.

Here’s how to perform an ABC analysis step-by-step:

• Identify the Objective: An ABC analysis can help you meet one of two targets: lower
procurement costs or raise cash flow by optimizing inventory levels of the right items based on
customer sales or production.
• Collect Data: The most common data to collect is the annual spend on each item. This data is
in raw purchase dollars. If it’s easy to calculate, you can gather the weighted cost, including
gross profit margin, ordering and carrying cost data.
• Sort by Decreasing Order of Impact: Use the ABC analysis formula to rank each inventory item’s
order by cost — from highest to lowest impact.
• Calculate the Sales Impact: For each inventory item, calculate its impact on sales as a
percentage by dividing the annual item cost by the aggregated total of all items spent. This
number is the percent, or fraction, that you will use to compare items in the list. Here’s the
formula:
% Impact = (annual item cost) / (aggregated total of all items spent) x 100

• Sort Items into Buy Classes: Once you define the classes, work on contract renegotiation,
vendor consolidation, shifting strategic sourcing methodology or implementing e-
procurement. Making changes in these areas can provide significant savings or ensure the in-
stock availability of Class A items. Take a holistic view rather than being strict about the 80/20
rule.
• Analyze Classes: Once categories and strategic cost management are defined, schedule reviews
to monitor the success or failure of decisions.
ABC Analysis Best Practices
ABC analysis best practices stress consistency, sales and attention to events that may affect stock levels
or value. Using technology to manage inventory is a best practice that simplifies the process from end-
to-end.

Apply these best practices when doing an ABC analysis:

• Keep Classifications Simple: Categorize items based on how frequently they move through
your organization. Fast-moving items are more subject to stockouts. You can also categorize
items based on value or gross profit margin. The most expensive items would be placed in Class
A, average price items in Class B and the least expensive in Class C.
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 • Assign Service and Labor Levels at the Same Time: Assign service levels based on an item’s
class. The Class A goods have the highest targets, while the last class products have the lowest
ones. For instance, managers would spend 10 hours reviewing 100 Class A items and 10 hours
reviewing 10,000 Class C items. Schedule cycle counting by classification, ensuring more regular
cycle counting is performed on Class A items (those which make the biggest and most
significant impact on sales performance) more regularly than Class B and C items.
• Segment KPIs by Class: Create distinct KPIs, corresponding reports and dashboards for each
class.
• Establish Performance Reviews: Conduct performance reviews when doing full inventory
maintenance or around schedules and rules that depend on ABC classifications.
• Review Surplus Stock: Decide if your current surplus stock levels make sense for your company.
In the global, just-in-time economy, the surplus stock may pose unnecessary risk and holding
costs. If it makes sense to hold onto this inventory, classify it correctly.
• Manage Across Locations: Supply chain managers need the ability to manage inventory across
physical locations.
• Count Inventory in Transit: When stocks move between locations, track the time between
shipment date and receipt date. Audits like these keep inventory records in order and ensure
you register damage or loss.
• Reclassify Purposefully: Remain flexible in how and when you reclassify items. You may need
to reclassify inventory periodically because of market changes, alterations in your customer
base or their buying habits, new products that become popular, or a shift in your KPIs or
business strategy.
• Consider Sales and Inventory in Tandem: Recognize the relationship between sales and
inventory. As sales increase, inventory turn increases, and you’ll need to restock against an
assumed schedule. Conversely, a downturn in the marketplace may call for a re-examination of
item classes and stock levels. Review pricing as well as promotional strategies based on
classification.
• Leverage Technology and Resulting Data: Inventory managers use automated systems to
complete replenishment processes, recognize upticks in demand and avoid fulfillment
problems. Use data to manage lead times and demand planning.
Using ABC Analysis for Cycle Counting
Cycle counts are a scaled-down version of physical inventory counts at set times during the business
year. ABC analysis ensures more frequent counts of crucial, high-volume items.
Cycle counting provides a system of checks and balances to ensure the inventory records in the
inventory management system are accurate. Regular cycle counting can be scheduled by classification,
ensuring more regular cycle counting is performed on Class A items — those which make the biggest
and most significant impact on sales performance — than Class B and C items.

History of ABC Analysis

The foundation of ABC analysis stretches back to the early 1900s, when inventor Vilfredo Pareto
discovered the law of the vital few and applied it to economics. Today, ABC is a pillar of inventory
management.
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1900s: Economist Vilfredo Pareto discovered the 80/20 rule that states income follows distribution in
inverse proportions. Since he discovered the principle in 1906 and noted its applications to economics,
industry, science and sociology, it has been used worldwide in a variety of disciplines.
1950s: Joseph M. Juran and W. Edwards Deming were founders and proponents of quality
management (QM), which relies on ABC analysis. They brought the concept to Japan, which helped
create the post-war Japanese Economic Miracle.
1960s: Based on quality management concepts, total quality management (TQM) employed the ABC
concept and enjoyed widespread popularity during the late 1980s and early ‘90s.
1970s: UPC barcoding and scanning came into use in retail in 1974. The Department of Defense
implemented a barcode inventory control system in 1981. Barcodes and scanning allowed for much
easier tracking of products throughout their life cycle, supporting ABC-based inventory management.
1980s: Lean Six Sigma is all about eliminating excess in manufacturing. Using ABC analysis in
conjunction with lean approaches started in the ‘80s and continues today.
1990s-present: As a central database that has robust inventory information, enterprise resource
planning (ERP) systems support ABC inventory analysis and its use in combination with other inventory
management methods. Today, ERP systems are used worldwide to assist with classified item inventory
management.

ABC-ANALYSIS IN EXCEL
ABC method allows you to sort a list of values in three groups, which have different impact on the
final result.

• highlight the with the greatest "weight" in the total result;

• analyze the groups of positions instead of an extensive list;
• to work on one algorithm with the positions of one group.
The meanings in the list after the application of the method ABC are divided into three groups:

1. A – the most important for the total of (20% gives 80% of the results).
2. B – average in importance (30% - 15%).
3. C - the least important (50% - 5%).

These values are not mandatory. Methods of determining the boundaries of the ABC-groups will
differ in the analysis of various indicators. But if significant deviations are detected, you worth to
think, what`s wrong.

Conditions for the using of ABC-analysis:

• the analyzed objects have numerical characteristic;

• the list of the analysis consists of homogeneous positions (you cannot comparably the
washing machines and light bulbs, because these goods are occupied so different
price ranges);

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 • were selected the maximum objective meaning (to rank the options on the monthly
revenue more correct than on the daily receipts).
For some values, you can use the ABC analysis methodology:
• the commercial range of goods (analyzing to profit);
• the client base (analyzing to the volume of orders);

• the supplier base (analyzing to the shipments);

• the debtors (analyzing to the sum of indebtedness).
The ranking method is very simple. But to handle of large volumes of data without special programs
is problematic. The tabular processor Excel greatly simplifies to the ABC-analysis.

The general scheme:

1. Identify to the purpose of analysis. Determine the object (which analyze) and parameter (on
what principle will be sorted by groups).
2. Make the sorting parameters in descending order.
3. Summarize to numeric data (parameters - revenue, the amount of debt, the volume of orders,
etc.).
4. Find the proportion of each parameter in the total.
5. Calculate to the share of cumulative total for each list value.
6. Find the value in the list, in which the share of cumulative total is approaching to 80%. This is
the lower limit of the group A. The top – is the first in the list.
7. Find the value in the list, in which the share of cumulative total close to 95% (+ 15%). This is the
lower limit of the group B.
8. For C - everything below.
9. Calculate the number of values for each category and the total number of positions in the list.
10. Find the shares of each category in total.

ABC-ANALYSIS OF COMMERCIAL RANGE OF GOODS IN EXCEL

We form to the study table with 2 columns and 15 rows. We insert the names of the conditional
goods and sales dates for the year (in the monetary value). It is necessary to rank the range of the
income (which products provide more profit).

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1. Sort the dates in the table. Excrete to the entire range (except the top) and press «Sort» on the
«Data» tab. In the dialog box has been opened, in the «Sort by» select «Income". In the column
«Order» - «Largest to Smallest».

2. Add in the table to the final line. We need to find the total sum of the values in the column
«Income». Go to cell B17 and press the hotkey combination ALT + «=» for quick access to functions
with filled parameters: =SUM(B2:B16).

3. To calculate the proportion of each element in the total amount. Create the third column «Share»
and appoint for the cells to percentage format. Enter the formula in the first cell: =B2/$B$17 (the
link to the "sum" we must do to the absolute). "Stretch" to the last cell of column. In addition, make
«Percent» of cells format CTRL+SHIFT+5.

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4. Calculate the share by accrual basis. Add in the table the 4-th column «Accumulated share». For
the first position, it will be equal to the individual share. For this purpose, the cell D2 enter: =C2.
For the second position – is the individual share + share of accrual basis for the previous position.
Enter in the second cell the formula: =C3+D2. "Stretch" until the end of the column. For the last
positions it must be 100%.

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5. Assign by the positions to one or another group. Less than 80% - is in the group A. Less than 95% -
is in the group B. Other ones – in the group S.

6. To be comfortable to use the results of the analysis, affix in front of each item to corresponding
letters.

So, we have been finished the ABC-analysis

using Excel facilities. The further actions of the
user – is the using of the findings dates in
practice.

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Sources

• https://www.netsuite.com/portal/resource/articles/inventory-management/abc-inventory-
analysis.shtml
• https://www.cgma.org/resources/tools/cost-transformation-model/xyz-inventory-
management.html
• https://www.youtube.com/watch?v=tzosTe2UOvs
• https://exceltable.com/en/analyses-reports/abc-xyz-analysis-in-excel

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