The word inventory in management science refers to the process of counting or listing items. As an accounting term, inventory gets listed in current assets and refers to all stock in the different production stages such as raw materials, work-In-process (WIP), finished goods, and maintenance, repair, and overhaul (MRO).  Inventory management is one of the vital management processes.  A good inventory management system prevents product and production shortages. It also prevents excess stock and stacking of additional raw materials.

ABC analysis (Always Best Control) is an inventory management method that helps to regulate the value of inventory items based on their importance in the business. ABC ranks items based on demand, cost, and risk data which inventory managers cluster into classes based on those criteria. This helps the organization to understand which products or services are most critical for them. ABC Analysis allows easy inventory analysis on any device.

Amazon does not stock every single item offered on its site. It stocks only those items that are popular and frequently purchased. If an ‘unpopular’ item is ordered, Amazon would then request it from its distributor who then ships it to the company. The item would then be unpacked and shipped to the respective customer.

The most important stock-keeping units (SKUs) are created on the basis of either sales volume or profitability, they are “A” category items, the next-most important are “B” category and the least important are “C” category. Some companies may choose a classification system that breaks products into more than just those three groups.

ABC analysis in cost accounting or activity-based costing is loosely related but different from ABC analysis for inventory management. Accountants use activity-based costing in manufacturing to assign indirect or overhead costs like utilities or salaries to products and services. Classifying inventory with ABC analysis helps organizations to optimize operations, and make clear decisions.

ABC Analysis is based on Pareto’s 80/20 rule

80/20 is a maxim that says that 80% of outputs result from 20% of all inputs for any given event. In business, a goal of the 80-20 rule is to identify inputs that are potentially the most productive and make them the priority. The rule signifies that 20% of goods deliver about 80% of the value therefore about 20% of a company’s inventory accounts for 80% of its value. Therefore, most businesses have a small number of ‘A’ items as compared to a larger group of B products and a big group of C goods. C category occupies the majority of items. ‘A’ items are annually consumed highest value. They are the highest priority items that cannot be afforded to be out of stock. ‘B’ items in inventory are required regularly but not as much as compared A items. Often B Items inventory costs more to hold than A items. C items occupy the rest of the inventory which has the lowest inventory value and make up the bulk of the inventory cost.

Toyota believes in making only what is needed when it is needed, and in the amount needed. This way, the company eliminates waste, inconsistencies, and unreasonable requirements, resulting in improved productivity. In fact, Toyota functions a bit like a supermarket. They make sure to stock the items that customers want when they want them,   but, at a quantity that helps them optimize cost savings.

Inventory categorization is essential with physical products because it protects the profit margins and prevents write-offs and losses for damaged inventory. It is also the first step in reducing outdated inventory which is calculated and considered for supply chain optimization, increasing prices, and forecasting demand.

How Is ABC Inventory Analysis Calculated?

ABC analysis is calculated by multiplying the annual sales of a certain item by its cost. The results tell which goods are high priorities and which yield a low profit this helps organizations to organize investment on inventory and focus on human and capital resources.

Platforms for the usage of ABC inventory analysis: Organizations use Microsoft Excel to do a basic ABC inventory analysis by listing each product or resource in descending order according to its product usage value; this helps the organization to calculate the total of each item in the cumulative amount. Determining the values for the A, B, and C categories helps in assigning group names to each item. The goods with the highest value get the closest attention.

Using ABC analysis for inventory helps better control working capital costs. The information gained from the analysis reduces outdated inventory and this can boost the inventory turnover rate, or how often a business needs to replace items after selling through them. Almost every type of business can benefit from ABC analysis. Companies worldwide use the method to improve processes and increase profitability.

ABC Analysis Benefits

There is a long list of benefits of applying ABC analysis to inventory management:

1. Better optimization of warehouse: The analysis identifies the products that are in demand. A company can then use its limited warehouse space to adequately stock those goods and maintain lower stock levels for B or C items. By carrying the correct proportion of stock based on A, B, or C classes, you can reduce the inventory carrying costs that come with holding excess inventory.
2. Enhanced Inventory Forecasting: Monitoring and collecting data about products that have high customer demand can increase the accuracy of sales forecasting. Executives can use this information to set inventory levels and prices to increase overall revenue for the company.
3. Improved product pricing: A surge in sales for a specific item implies increased demand and a price increase for those products may be sensible which improves profitability.
4. Helps in negotiations with suppliers: Since companies earn 70% to 80% of their revenue on ‘A’ items, it makes sense to negotiate better terms with suppliers for those items. If the supplier doesn’t agree to lower the prices, organizations can negotiate post-purchase services, free shipping, or other benefits for cost savings.
5. Planned resource allocation: ABC analysis is a way to continuously evaluate resource allocation to ensure that ‘A’ category items align with customer demand. When demand lowers, re-classify the item into ‘B’ or ‘C’ can help in making space for the new Class A products.
6. Better customer service: Service levels depend on many factors, like quantity sold, item cost, and profit margins. Once the most profitable items are determined it helps offer better service levels for those items.
7. Better product life cycle management: ABC Analysis helps in understanding the stages of the product life cycle (launch, growth, maturity, or decline) which are critical for forecasting demand and stocking inventory levels suitably.
8. Maintaining and regulating high-cost Items: Category ‘A’ inventory needs to be observed closely and is important to a company’s success. Prioritizing and monitoring demand is important for maintaining suitable stock levels so that enough key products are always at hand.
9. Streamlined supply chain management: Use of ABC analysis of inventory helps in determining and consolidating the selection of suppliers or shifting to a single source to reduce carrying costs and simplify operations. ABC ranks items on-demand, cost, and risk data, and inventory managers group items into classes based on those criteria.

Apple, the consumer electronics giant keeps as little inventory on hand as possible. By lowering the amount of stock on hand, Apple carries a lower risk of overstocking and chalking up dead stock in its warehouses. As explained by Tim Cook, CEO of Apple, “Inventory is fundamentally evil” You kind of want to manage it like you’re in the dairy business. If it gets past its freshness date, you have a problem.”