ABC analysis is an inventory management principle which stands for Always Better Control. It is based on the Pareto principle (20% of a commodity accounts for 80% of the net result) and can be very useful for management of a company’s inventory. In this article, we consider what ABC analysis is exactly and how it is calculated, an example of it in action and some pros and cons of its implementation.
The ins and outs of ABC analysis
ABC analysis is based on the Pareto principle also known as the 80/20 principle or the law of the vital few. Whatever you call it, the fundamental basis to it is that 80% of the effects come from 20% of the causes. In inventory management, this can be reworded to say that 80% of revenue is attributable to 20% of inventory. The analysis part of this involves dividing your inventory into three categories representing the most valuable (A), inventory of moderate value (B) and the least valuable (C). As you can probably guess, the 20% of inventory accounting for 80% of revenue is category A. Category B should comprise approximately 30% of inventory and category C should comprise approximately 50%. To actually categorise your inventory, you will need two sets of data:- The demand or annual usage of each product line in inventory
- A metric you are aiming to improve for each item (e.g. revenue or purchasing costs)