17 May, 2022 by
Payal Kheradiya
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What do you mean by ABC ANALYSIS ?

One of many parameters to increase revenue in any business is to identify the product from the catalog which is generating the highest revenue, having a significant impact on overall inventory cost. Every single item that we order may not have equal value. Some may cost more, some are used more while the rest come under both categories. Again for medium scale to large scale industries, identifying such products manually becomes not only time consuming but also a tedious, erroneous procedure leading to a loss in time and money both along with misutilisation of human resource power. Thus there arises a need to implement an automated process that does such analysis of differentiating the products based on their overall inventory cost.

The ABC analysis is an inventory categorization technique derived from Pareto Principle, which provides a mechanism to identify items from the catalog which has a significant impact on inventory cost, and also a mechanism to differentiate products into different categories that require different management and controls. The ABC analysis addresses that inventories of an organization are not of equal value. In ABC analysis inventories are divided into 3 categories:

A - The most important(20% gives 80% of the result)
B - Average in importance(30% gives 15% of the result.)
C - The least important(the rest 50% gives 5% of the result.)

Above mentioned A, B, and C categories indicate that for products under the A category 80% of your revenue comes from just 20% of your inventory. For products under category B - 15% of your revenue comes from 15% of your inventory. For products under category C - 5% of your revenue comes from 50% of your inventory.

Thus ABC analysis ranks items based on demand, cost, and risk data, and inventory managers group items into classes based on those criteria. Thus using such analysis helps business leaders understand which products or services are most critical to the financial success of their organization.

Thus the business can identify that the most important stock-keeping units (SKUs), based on either sales volume or profitability, are “Category A” items, the next-most important are Category B, and the least important is Category C.

Objectives of ABC Analysis:

For any business, implementing any process, or method, the ultimate objective is to secure the economy. ABC analysis is one of these processes its main objective is inventory management.

The ABC analysis helps the business to discriminate among all products and concentrate on the most important items first, then on the second-grade items, and then on the rest — in the third grade.

The ABC analysis objectifies to help businesses determine where and what resources to utilize at its best to optimize results.

In short, ABC analysis helps businesses identify where they can derive the most benefit, and thus the main objective is to increase business efficiency.

Knowing the importance of ABC analysis, the next point of interest in mind that arises is How actually ABC analysis is calculated? So next let us understand the calculations of ABC Analysis.

How to Calculate ABC Analysis?

ABC calculations can be performed on individual product groups or a wide range of inventory. The steps involved in the ABC Calculation are as follows-

  1. First, the annual number of products sold is multiplied by each item's cost, and thus the utility of that product is derived.
  2. Arrange a category of every product in the descending order based on its utility value...
  3. Add the annual usage value of the products and also the total number of products. 
  4. Find out the cumulative percentages of products sold and annual usage value.
  5. Now, divide your products into three categories, finally, in an approximate ratio of 80:15:5 for category A, category B, and category C respectively.

Example of ABC analysis:

Step 1: Find Annual Usage Value

Step 2: Arrange products to descending order based on its Utility Value.

Step 3: Add the annual usage value of the products and also the total number of products.

Step 4: Find out the cumulative percentages of products sold and annual usage value.

Step 5: Now, divide your products into three categories, finally, in an approximate ratio of 80:15:5 for category A, category B and category C respectively

Benefits of ABC Analysis

As ABC Analysis helps you to identify & categorize Products to

As a business owner, you would be able to

  • Take the best decision over Working Capital to be invested in which Products delivers  highest Sales

  • Take decisions over managing the most Important products more closely

  • Save Energy, time, and money by focusing more on the highest-selling Products.

  • Take decision over Which products’ Selling Price should be increased and which not based on the demand of Products?

For example, as by ABC analysis, you are able to segregate Products that are most in-demand, so increasing the Sell Price of such Products can lead your Business to more Profit

  • Reduce the storage expense by maintaining an appropriate level of Stock-based on A, B, and C category and reducing Inventory Carrying Cost that comes with holding excessive stock of non-demand Products

  • Decide, negotiating the Purchasing Price of which Products from the supplier is more Profitable 

For example, negotiating with the Purchase Price of class A category Products or asking for other service levels like reduced shipping cost, down payment reduction, and post-purchase services may again lead to the most Profit for Business

  • Take the decision over discarding Less in Demand Products if they are excessive in stock to avoid unnecessary maintenance costs.

  • Increase Inventory Optimization by utilizing most Warehouse space to adequately stock Most in-demand Class A category products and maintain lower stock levels for Class B and lowest for Class C category products.

  • Decide that Stock Out of which Products should never be allowed and thus

“Invest right on Inventory Management Software that calculates and maintains Stock levels in an Automated way”

Limitations of ABC Analysis:

We all know that with advantages there come limitations too, ABC analysis not being excluded suffers from certain limitations too. 

ABC analysis is based on grades i.e. by V.E.D — Vital, Essential, and Desirable, some products with less monetary value but provides large profit because of the great difference in Purchase and sales cost of the product, are considered into lower categories but it may happen that maintenance cost also being less, such products are also beneficial to business.

Other aspects like its maintenance cost, transferable cost, and other such service parameters are not considered.

The result of ABC analyses will be different depending upon the nature of obsolete items the inventory position is analyzed according to the value I.e., XYZ analysis, 

Moreover, the ABC analysis needs periodical review and updating because if demand changes and thus the number of products sold may change, and thus the category to which these products belong may also change.

All in one

ABC analysis is one of the best techniques when Entrepreneurs and Inventory Managers are willing to classify Products based on the Revenue that they generate. Not only identifying the most important products but such segregation also helps in many important decisions on Inventory Management, focusing on essential Products rather than all, monitoring Price variation, planning over expenditures appropriately, and many more.

Well, it is easily understandable How important ABC analysis is to categorize Inventories based on Revenue Generation but as such classification is not possible manually you need to Invest in appropriate Futuristic Inventory Management Software.
Payal Kheradiya 17 May, 2022
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