ABC Analysis (also known as the ‘always better control’ method) is an inventory control technique that classifies products into three main categories: A, B, and C. This classification is based on which products are valuable to the business and generate the most income.
Category A products are of the highest value to the business, category B products are of moderate value while category C products are of the lowest.
Benefits of ABC Analysis
Below is a list of some major benefits of implementing ABC Analysis:
Accurate Demand Forecasting
ABC analysis can help businesses in accurate demand forecasting. This is because the analysis is carried out after collecting relevant data like price per unit about products.
Purchasing and selling according to this data helps streamline the supply chain as well.
Better Management of High-Value Inventory
The classification of products can help businesses focus more on high-value products. These are the products that bring the most revenue to the company and are key to a business’s success.
Such products are carefully managed by companies within the warehouse and throughout the supply chain to maintain availability and meet customer demand.
Improved Pricing Strategies
ABC analysis identifies high-value products so that businesses can create exclusive strategies for them to drive sales. However, this doesn’t mean that companies can ignore the products in the B and C categories.
These products are given separate pricing strategies that can drive their sales according to their market value.
These benefits can be fruitful for businesses. Let’s now explore the process of carrying out ABC analysis.
What is the Process of Carrying Out ABC Analysis
Businesses can follow these steps to conduct ABC Analysis:
Gather the Inventory Data
As the first step of ABC analysis, businesses should gather their inventory data. The products in stock should be listed, along with the relevant information. This includes mentioning the selling price, unit cost and annual sales volume of each product.
All this data will be valuable when it’s time to divide the products into categories.
Calculate the Value of Total Inventory and Products for Classification
In the next step, the data collected is used to calculate the value of individual products and the total inventory. The individual value of products can be calculated using this simple formula:
Product Value = Annual Demand x Price per Unit
For example, suppose three products, X, Y, and Z, have annual demands of 3000, 1500, and 1300 units, respectively. Each unit of product X costs $20, product Y costs $10, and product Z costs $9.
Product Value of X = 3000 x 20
= $60,000
Product Value of Y = 1500 x 10
= $15,000
Product Value of Z = 1300 x 9
= $11,700
Value of Total Inventory = 60,000 + 15,000 + 11,700
= $86,700
Classify According to the ABC Categories
Based on the calculations done in step two, it’s time to classify products into categories. Here’s how the classification based on product value can be done:
- Product X has the highest contribution to the total inventory value that is $60,000). This will place Product X in the A category.
- Product Y has the second highest contribution to the total inventory value that is $15,000). This means that Product Y will be placed in the B category.
- Product Z has the lowest contribution to the total inventory value that is $11,700). This will put Product Z in the C category.
Implement Controls
After the classification, businesses can then strategize separately for each product. Category A products should be monitored regularly with rigorous sales strategies while category B products are loosely managed with a medium level of control. On the other hand, category C products can be monitored periodically.
Additionally, businesses should schedule regular reviews to check if the value of each product remains the same or changes for the business.
This process can present challenges for businesses when implementing ABC analysis.
Challenges in Implementing ABC Analysis
Here is a glimpse of some challenges in implementing ABC Analysis:
Ignores Product Demand Patterns
While calculating the product value, there is a chance that a high figure may be calculated even if the product demand is low. This may happen if the price per unit of the product is high.
This high figure can increase the value calculation of the product in comparison to other products.
Doesn’t Consider Seasonal Demand
Another aspect of not considering product demand is ignoring seasonal demand. For example, a product may be placed in Category A because it has a high demand, but only for a season.
On the other hand, a product may be placed in Category C because it only has high seasonal demand and not annual demand.
Lead Time Management
If a product has a high lead time, putting it in Category A can become a challenge. This is because a business will invest more in this product. However, if it is not available when customers need it, the delay might disrupt the sales and affect revenue.
Following simple tips can help overcome these challenges.
Tips to Effectively Implement ABC Analysis
The following are some effective tips that can facilitate implementing ABC Analysis:
Simplify the Product Classification Step
It is crucial for the business staff to know which products are placed in which categories. For this, it is essential that the criteria for classification are simple.
For example, some generally used criteria are product’s price and demand. These are easily comprehensible by the members of the company, allowing operations to be performed easily.
Set Labor According to the Product Classification
The classification of products means that each requires a different level of focus. This is why it is advised that each category be assigned a different set of labor and resources.
Each set must have the relevant data like inventory levels so that exclusive strategies can be implemented effectively.
Review Product Classification Individually
The factors on which the product classification is made can change based on economic shifts, market trends and consumer preferences. For example, product demand can increase or decrease, which will affect the product value.
This means that the position of the product should also be updated accordingly.
Conclusion
ABC analysis can prove to be an effective tool for businesses to determine the value of their products and strategize accordingly. Dividing products into categories can also help the labor to divide their efforts into managing products according to their value.
