The Ultimate Guide to ABC Analysis for Inventory Management

ABC-analysis-of-inventory-management-

When it comes to inventory management, many businesses find themselves at a crossroads to keep an optimum level of stocks and prevent issues like stockouts and overstocking. In this blog, we will cover ABC analysis for inventory management – where the inventory is categorized into three categories (A, B, and C) based on business value. By understanding how to do an ABC analysis, you will be able to prioritize your inventory, streamline your operations and make better business decisions. 

What is ABC analysis?

ABC analysis is an inventory categorization method that allows businesses to identify their most (and least) valuable inventory. Per this method based on the Pareto Principle, the inventory is divided into three categories, i.e., A, B, and C, in descending value. The items in the A category have the highest value, B category items are of moderate value, and C category items have the lowest value. It is also called “Control by Importance and Exception” and “Proportional Value Analysis” since the categorization of the inventory items is done based on their relative value.

What-is-abc-analysis-in-inventory-mangement

Let us take an example of ABC analysis to understand this better.

Richa started a new business in organic cosmetics. She currently sells three categories of products: Kohl, lipsticks, and foundations. To better manage the inventory in her small-scale business, Richa decided to perform the ABC method of inventory analysis. Richa had to understand what products are the most valuable to her business and which products bring in the most negligible value. After a thorough analysis, Richa segregated the inventory into the following categories:

Category A: This category included the products that brought in the most revenue. The foundations that Richa produced were a hit among the public. They cost the most among all her products and were the most profitable.

Category B: This category included products that brought in enough revenue but not as much as those in category A. Richa included her lipsticks for their value compared to the other products.

Category C: This category included products of the least value to the business. Kohls brought in the least revenue compared to the other products due to their low price, and hence were added to this category.

In summary, the essential characteristics of each category in the ABC analysis are:

Inventory Management ActionCategory ACategory BCategory C
PurchaseHigh frequencyLess frequentLow frequency
ControlStrictModerateLow
ManagementTop levelMiddle levelLow LEVEL
ConsumptionHighModerateLow
ImportanceHighModerateLow

What are the benefits of ABC Analysis?

There are several reasons why you should opt for an ABC analysis of your inventory. Some of them are:

Inventory optimization

Businesses often tend to have surplus inventory that takes up the storage space and increases the storage cost. Performing the ABC analysis for inventory management helps you decide which inventory or items need to be stocked adequately, helping you have savings on various fronts. 

Supplier negotiation

Per the Pareto principle, businesses make 70-80% of their revenue from Category A items. Knowing which items fall into this category helps you negotiate better terms with the suppliers for these items instead of all the inventory.
ProTip: If the supplier doesn’t agree to changes in the actual pricing, you can negotiate terms like free shipping, post-purchase services, etc.

Increased profitability

This is possibly the most significant benefit for businesses. Knowing which inventory is popular among your consumers can be an advantage for you to increase the prices (reasonably). It also helps you understand which products are performing badly, and paves the way for revamping your marketing strategy.

Demand forecasting

We cannot stress enough the top-level demand forecasting in efficient inventory management. Knowing which items have higher demand can help you prepare your inventories accordingly. It will also help you forecast your sales efficiently.
ProTip: Leverage automation for demand forecasting. Tons of software are available today that allows you to forecast demand accurately. Embracing automation can help you track your inventory effectively and make informed decisions leading to increased profits. Here’s a list of the best demand planning software per G2.

Cycle counting

Cycle counting provides a system of checks and balances to ensure the inventory records in the inventory management system are accurate. ABC analysis lets you have frequent checks of the most popular, high-selling items. It, in turn, helps you restock and replenish the inventory to avoid stock out.

Now that you’ve seen how ABC analysis for inventory management can help you better your inventory management strategy, we will tell you how you can perform ABC analysis for your business.

How to perform ABC analysis for inventory management?

ABC analysis can be performed in 6 easy steps as explained below.

Identify Objective

Understand what you want to achieve by performing the analysis. Based on where your business stands, the objective can vary from reducing procurement costs and increasing cash flow to developing policy guidelines for selective controls.

Collect Data

Data is the powerhouse of any business. Collect all relevant data that would help you understand how much you spend, what profits you get, which products are in high demand, and so on. The annual spend on products can come in handy here.

Sort Inventory based on cost

Sort the inventory in decreasing value of impact, i.e, the item costing the most to the item costing the least. This aids in understanding where most of your capital spend goes.

Calculate Sales Impact

Determine the impact each of the items has had on your business annually. This would help classify the items that bring in the most value for your business.

Classify Inventory

Take the data from the previous two steps and classify and categorize the inventory into three categories, i.e. A, B, and C in descending value. Negotiate your contracts with the suppliers, strategize the product prices, and ensure you have the right amount of inventory in Category A available.

Analyze classes

Analyze how the new categorization performs. Be flexible in how and when you classify items. You may need to reclassify inventory time and again because of market changes, variation in your customer buying patterns, new products that become a trend, or a revamp in your business strategy.

With inventory management softwares like Quickbooks Commerce, Zoho, Shopify, etc. you don’t have to perform manual calculations to understand the three categories. The tools will automatically tell you – all you have to do is build strategies on how you will manage the three categories for maximum profitability

Now that you know how to perform an ABC analysis, we will tell you what to do with your best performing and worst performing inventory.

What to do with your best-performing inventory?

Once your ABC analysis is done, it is time to get your creative juices flowing and make decisions to optimize your inventory to make the maximum gain. When you know which inventories fall under category A, make sure to think of ways to leverage the knowledge. 

You can start by reasonably increasing the prices of the goods in category A. You know these items are hot-selling, and your customers would buy them despite a slight increase in the price.

You must also make it a point to improve your relationship with the category A suppliers. This way, you will be able to make better negotiations for the items and ensure you get the best deals out of it. You can improve your relationship by taking baby steps — Establish an automated and efficient ordering process, pay on time, demonstrate empathy, and more.

One of the worst things that can happen to category A products is stock out. As the demand increases, the inventory decreases. What you can do in this case is have multiple suppliers for the same product. It doesn’t mean you order from all of them. What we recommend is building cordial relationships with multiple vendors so you never run out of category A inventories.

ProTip: Safety stocks come in handy in such situations. They are a small surplus of inventory you keep on hand in case of a change in market demands. You can calculate the same using the below formula.

Safety stock = (Max daily sales x Max lead time in days) – (Average daily sales x Average lead time in days)

Be sure to keep track of your inventory in real-time. It helps you know when you should replenish your stock. It also is advisable to invest more in category A inventory if you know the demand is constant. Make sure you insure your inventory to prevent any mishaps.

What to do with your worst-performing inventory?

While category A goods sell like hotcakes, the inventory in category C needs an extra push to avoid being dead weight. It is of utmost importance to have a proper strategy to ensure you don’t end up cutting losses because of this inventory. Generally, the ultimate aim for many is to get rid of the category C inventory. 

You can start by providing discounts on these items. Reducing the price of items might seem like a loss, but the cost of storing these items is significantly higher and a greater loss to the company.

You can also run sales and contests that would help sell these items. Many brands have ‘Clearance sales’ throughout the year to sell off the items that do not usually perform well.

Another tried and tested method is bundling. You can bundle the worst-performing item with either a category A or category B item. That way, you make sales as well as get rid of items in category C that wouldn’t sell otherwise.

A lesser known tactic is to donate your category C inventory. Not only does it help get rid of the dead weight, but also help with a reduction in taxes. It also helps improve your social image and aids in your corporate social responsibility initiatives. 

Our favorite trick is to revamp your marketing strategy for category C inventory. Tell your customers what they’re missing out on. Show them why they should be buying these items. Rethink the positioning and placement of these inventories, and they will start selling quicker than you can imagine.

We have more tips on selling your surplus inventory in our recent blog post that you can check out.

While ABC analysis has tons of positives, it also has drawbacks — It doesn’t account for new product introductions, seasonality, change in trends, etc. Ultimately, the most important thing to do is consider the nature of your business and decide if ABC analysis is the right way to go for your brand. You can do that by answering a few questions like are the processes and systems in place for the effective operation of the ABC analysis method? Do you have access to all data on each item in your inventory? Have you assessed the changes the implementation of ABC analysis would bring?

Companies worldwide use this method to improve their supply chain process and increase profits significantly. If you’ve already done ABC analysis before, tell us what was the most challenging part of the process in the comments below.

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