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Sam Phipps
Marketing Manager
Before we dive into the topic of ABC Analysis, imagine that you have a range of 10,000 SKUs… over 1,000 customers…and hundreds of suppliers.
For all of these SKUs, you have to determine an inventory strategy e.g.
And many more!
The life of someone in the supply chain is not easy! Therefore, it is vitally important that you focus on the right things. But what are these right things? Which products should you focus your attention on?
25% of your items do nothing!
According to the classic Pareto analysis, 50% of the products create just 5% of the total margin. Of course, this is still 5% and cannot be ignored. But should we give these items the same focus, investment and importance as the top items that really make us money?
What if we dive a bit deeper? A completely different picture starts to emerge.
In this article, we will explore how you can identify your most important items to implement more effective inventory strategies!
But first, let me explain the laws of Pareto and how they work in practice.
ABC inventory analysis is the process of classifying inventory by priority based on given criteria.
With the insights this analytical approach provides, we can identify meaningful opportunities to optimise inventory levels.
This useful tool helps supply chain teams to reduce carrying cost and unlock working capital. But more importantly, a good ABC analysis should help increase sales turnover through attaining better availability on the products that matter most to the customer. As a result, businesses that take advantage of this approach run leaner and more efficiently.
When you’ve finished, your inventory will be divided into three core categories – A, B and C – based on strategic importance.
A category: Products that are important and thus require tight control
B category: Products of lower importance but that must still be managed with a medium level of control
C category: Products of lower importance that require the simplest and easiest level of control
The name “ABC” suggests that we only have 3 classes. However, if you wanted, you could distinguish 10 classes. However, this could make the data very difficult to interpret. We will explore this later on.
The purpose of an ABC analysis is to logically structure your assortment and identify your priorities within it.
Once you have categorised your assortment by importance, you can implement more optimal inventory strategies based upon their ABC status.
Furthermore, it will ensure your business focuses their investment and priorities in the areas that will have the biggest impact on the business.
A good ABC analysis provides you with lots of interesting insight into your assortment. This, in turn, can be used to drive optimisation initiatives that save money, improve service or boost profitability
Here are just a few examples of how your business could benefit from completing an ABC analysis:
Ultimately, you should use this handy analysis to spend time and resource, both of which are in short supply, on the things that really make a difference!
ABC analysis can be performed on a wide selection of criteria such as:
– Sales volume (historic or forecasted)
– Cost of Goods Sold (COGS) (historic or forecasted)
– Sales Turnover (historic or forecasted)
– Margin (historic or forecasted)
– The steps required to complete an ABC analysis depend on the level of complexity and detail you wish to explore. But first, let’s consider the goals of your analysis.
The first thing the management team must do is to determine why we are making an ABC analysis. Below are listed a few examples…
The objective that we are aiming for immediately determines the criteria which form the basis of the ABC analysis.
Should the management team want to understand the assortment of ‘range planning’ (#1 above), then ideally data is needed such as:
Should the objective be associated with warehouse layout (#3 above) then we need data such as:
Now that we understand the goals of the analysis. How complicated does our analysis need to be to achieve the desired insight?
Are you looking for a simple ABC analysis based on just one criterion? Or do you need a more detailed ABC analysis that looks at multiple factors?
For a quick and easy result that everyone can understand, it probably makes sense to go with a simple analysis. However, if you need a more granular breakdown of your assortment, you need to dive a bit deeper.
Completing a simple ABC Analysis
Are you setting up a new warehouse & would like to know what your fast runners are so that these items can be stored in easy access locations? (e.g. low down & near the front of the warehouse).
Then a simple ABC on just the number of order lines or sales turnover would suffice.
To complete this single-dimensional ABC analysis, we simply take the most important criteria and categorise products based on to extent to which each product contributes.
More complex multi-dimensional ABC
However, what if your business is interested in identifying which items make the most money for the business to order to help the planning team prioritise these products?
In this instance, we need a multi-dimension ABC. For this example, we could use:
Dimension 1 => Margin, & then combining with a 2nd dimension ABC
Dimension 2 => such as the Number of Order Lines or perhaps Sales Volume
By looking at two different dimensions we can gain much richer insight into how each item performs on the two factors in question. For example, if a product ranks low in terms of margin but high in terms of number customer orders, we can still see that this is a key product within our assortment.
There are lots of criteria we could use to conduct an analysis. However, it’s important that you select the criteria which best fits the goals of your analysis.
Here a just a few examples of criteria you could use and what it tells you…
Ultimately, it is the management team who should determine which criteria are important as well as how many criteria should be used to complete the analysis.
Now that you have determined if you need a simple analysis or something more complex and the management team have outlined the main criteria, the next step is to perform the analysis.
There is lots of slightly different approach to undertake an ABC analysis.
However, there are typically 6 main steps:
1) Extract the data with the selected criteria over the desired date range, at an item level
2) Then take each ABC criteria in turn & order from highest criteria to lowest
3) For each item calculate the % that the item contributed to the total of all items
4) Classify the items into their ABC groups. Typically:
– A items = those items representing the top 80%
– B items = those items representing the next 15%
– C items = the remaining items making up the final 5%
5) Repeat this process for the 2nd ABC dimension
6) Combine the 2 ABC’s, with the highest ABC giving the overall classification – i.e. A on 1st dimension & C on 2nd dimension would become an A item
After completing the ABC analysis, each product should be classified as an A, B, or C item. For multi-dimensional analysis, the results should look something like this:
Example of an ABC analysis
To make a good analysis, you need good data. But who should be the owner of this data? Should it be the IT team, finance, operations, or even management?
This is a difficult question to ask. And many businesses don’t have a clear-cut answer. You probably think that it depends on the business in question…and to a degree, you would be correct!
Okay, there could well be a technological process or system that the IT team need to support. However, master data is everyone’s problem. From the demand planner to the CEO, we all have a duty to keep it clean. After all, everybody benefits!
In this article, we have explored what steps you need to take to complete an effective ABC analysis.
Hopefully, by following these simple points, you can take action now to help maximise the value of your assortment and identify meaningful opportunities to reduce inventory levels!
But why stop there?
Find out how you can take your approach to assortment management to the next level with our simple guide to optimising your product range throughout every stage of the product lifecycle. Click here to read more…
