ABC Analysis is an inventory management technique used to categorize inventory items based on their importance w.r.t. the business. All the items in the inventory are not of equal value or demand. Some items cost more as compared to the rest of items, some items have more demand and others may be having less demand. So it is always useful to segregate the items based on their importance for strategic business decisions and management of these inventory items.
How the ABC Analysis is Carried Out?
The first step in ABC analysis is to determine the inventory value of all the items. This is done by multiplying the price of the item to their consumption volume during the given period.
Inventory value of the item= Consumption volume of the item * Price of the item
The second step is to sort all the items as per highest to lowest inventory value.
In the third step, value of each item is calculated as a percentage of total inventory value.
% Inventory Value = (Inventory Value of the Item *100)/ (Total Inventory Value of All Items)
The final step is to categorize all the items according to their inventory value percentage. For e.g., the items having 80% of total inventory value may be grouped in ‘A’ category. The items having 15% of inventory value may be grouped in ‘B’ category and the remaining items having inventory value of 5% may be kept in ‘C’ category. The limit for fixing categories may very as per the requirement of the organization.
Let us now understand, how the categorization of inventory items helps in making business decisions and management of the inventory.
The items of category ‘A’ are more important from business decision point of view. Usually these items have a high value and managing these items means that substantial part of the inventory is managed. Since this category has large market value, therefore this require frequent value analysis.
Category ‘B’ inventory is the next important inventory from strategic decision point of view. These items are less important than category A items but need to be managed.
The items in category ‘C’ are of least importance and not much attention is required to manage these items. These items have very less market value therefore they are the last priority from the strategic point of view.
Why the ABC Analysis is Important?
Often it is seen that the items in category A, means having the highest inventory value are less in numbers and therefore easy to manage but the items of category C, having the lowest market value are in large quantity. Therefore, categorization of inventory is very important so that the critical inventory items, crucial from strategic point of view may be segregated and managed on priority. ABC Analysis can help in this in a great way.
Let us understand the importance of ABC analysis with the help of a chart.
Above graph shows cumulative % if units of inventory on the X- axis and cumulative % of total inventory value on the Y- axis. It can be easily seen that category A, i.e. only 20% of units contribute to approximately 80% of total inventory value while the category C, which contains approximately 60% of units, contribute very insignificantly to the total inventory value. If the company manages only 20% of units of category A, it will be able to manage a substantial part of total inventory and most of the resource which would had been otherwise used to manage category C inventory, can be saved easily with the help of ABC analysis.
ABC Analysis is a great tool for inventory management, which can help in identifying and categorizing critical inventory items.
Advantages of ABC Analysis
- ABC analysis helps in better resource optimization. The resource allocation optimized because the most critical inventory is provided resources in priority and the inventory having less market value is given least priority.
- The inventory having more demand is known by ABC analysis. A company can use its precious warehouse spaces and shelf spaces to store and display that crucial inventory.
- ABC analysis helps in better demand forecasting. As the inventory in more demand is known, the future quantity to be ordered for this inventory can be anticipated easily.
Disadvantages of ABC Analysis
- ABC analysis requires special effort and extra resources to categorize the inventory.
- As the categorization is based only on the financial value of the inventory, it ignores other factors to take into account, which may be crucial for decision making.
ABC analysis is an important tool for inventory management. It not only saves extra effort and resources in managing less important inventory but provides numerous other benefits as mentioned above. The organizations therefore, should make it a practice to categorize their inventory as per the ABC analysis to manage these effectively.