ABC Analysis in 3 minutes

As ABC analysis is intended to be accessible to a diverse audience within the company it can be argued to be one of the more crude inventory management techniques. When it first emerged it was intended to minimize the clerical overheads associated with inventory. However, with the advent of low cost perpetual inventory systems and barcode readers, this practice has gradually faded away. As such, from a purely reporting perspective ABC analysis still has its uses but, with the computational power we now have at our disposal, simpler methods such as product scoring perform better.

ABC Analysis is one of the most simple inventory categorization methods…. which divides items into categories based on their perceived importance.

The method has it’s roots in the Pareto principle, a technique which first originated in the 19th Century when a guy called Vilfredo Pareto observed that 80% of the wealth in England belonged to about 20% of the population. Around half a century later it was realised that this rule could be applied to a wide range of things other than basic economics, and the the 80/20 rule was born!

So why is this rule interesting for a Supply Chain? Well let’s start off by using the example of a supermarket. Here, it can be shown that 80% of overall consumption comes from only 20% of items within a store.

When you think about it, this is certainly true…..just think about how much smaller the shelf for batteries is, and how much less often it is replenished when compared to the mountain of Coke that is refilled on a daily basis!

If you’re a store manager this fact is pretty important as it means that just 20% of your total product offering is bringing in about 80% of revenue! ….so these are probably worth focusing on right!?

This idea of dividing up resources depending on the importance of a product is where the real benefit of ABC analysis lies. So let’s stick with our store example and take a look at the spectrum the store manager can use to review tems:

  • First off we have our ‘A-items’, who much like those A grade students in school, are the top performers! These are the goods where the annual consumption value is the highest and the ones which generate all of that revenue.
  • At the other end of the spectrum we have our slow movers which for the sake of simplicity we will call ‘C-items’. This is where our humble battery would live!
  • In the middle of our spectrum are the items which have a medium consumption value. This would be something like shampoo, which our store manager would need to keep an eye on but is not a product which typically has a high daily demand.

What we have shown here is just three options but it is worth bearing in mind that ABC analysis is not just limited to these three categories. Most companies actually use a higher level of granularity which in practice looks a little bit like the rather pretty curve you can see here.

So now we know which category each of our products falls into, what does it actually mean to how we work?

  • Well those A-items need to be looked after, and as such would have tight inventory control, better sales forecasts and perhaps even more secure, prioritised storage areas.
  • Here reorders will be frequent, on a weekly or even daily basis with the main aim of the game here to avoid stock-outs at all cost.
  • On the other hand a typical inventory policy for C-items may consist of having as little as 1 unit on hand, and reordering only when an actual purchase is made.
  • This approach can lead to being stocked-out but as they present both low demand and higher risk of excessive inventory costs this is deemed to be acceptable.
  • As such for C-items, the question should not be how many units do we store, but rather do we even keep this item in store?

So it all sounds great in theory, but where do the limitations lie? Well the main problem is that ABC analysis, for all its virtues has already been around for multiple decades. Whilst it works fairly well for a disorganised human to prioritize work, it is far less useful for a computer, which easily has the power to look at the individual characteristics of every item on its own merit.

So that’s an overview of ABC analysis - if you have any questions please don’t hesitate to get in touch and we will see you again next time!

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