graph with text ABC analysis

How to calculate an ABC analysis

by Fleur Smits - Straathof

1. What is an ABC analysis

Back to the basics, an ABC analysis is a method for inventory holding companies to classify their inventory into different categories. The three categories are A, B and C and give an indication of the importance of an item to the business. If an item has a low contribution to the company’s performance it will be classified as a C item. When the item is however a fast mover and has a high impact, it will be classified as an A item.

2. Why is it important to classify your products

Often planners spend a lot of time managing items that have a very low contribution to the company’s profit margin. The main reason is the fact that these items often show a high volitility and are therefore difficult to manage. It is however vital for companies to focus on the right items. For example items which have a high contribution to the companies turnover. Primarely since assortments are growing because of for example e-commerce and the ever more demanding customers you need to spend your time wisely. Performing an ABC analysis will help companies to bring focus.

3. ABC classification categories

The Pareto principle, also known as the 80/20 rule, indicates that 80% of a company's turnover is generated by only 20% of the assortment. These 20% are the 'golden eggs' and should be treated with care and dedication. Often the ABC analysis is used instead of the Pareto method, dividing the complete assortment in three categories.

ABC classification in Inventory management

4. ABC analysis criteria

An ABC analysis can be based on different criteria, and is not limited to the following criteria:

ABC analysis criteria in inventory management

As most companies have the goal of generating revenue, (gross/net) margin is often forms the basis of an ABC classification. ABC classifications can significantly differ per industry. Furthermore there will be a difference per company as the company’s strategy has a big impact on a company's product range. If you want to be able to supply a full product range, you will probably have a very wide assortment often leading to many C articles. Because of this reason often spare part businesses show a big ‘long tail’. Meaning the amount of C items is huge in comparison to the amount of A and B articles. The desire to always be able to deliver requires a company to also stock a big variety of C articles.

5. ABC analysis graph

The below graph illustrates how an ABC analysis could look like:

ABC analysis graph

In this particular example A-articles contribute for 70% to the company's margin, B-articles for 20% and finally C-articles for 10%. The graph clearly shows that 70% of the articles only contribute for 10% to the company's margin. Often C articles require a lot of attention because of their vilatility and the complexity of properly forecasting their future demand. While A articles are most important to the business, therefore they should receive proper attention and should not be neglected.

6. ABC analysis calculations

An ABC classification can be performed on the complete product range of a company or for example also on an individual product group.

STEP 1

Plot the required data

Plotting data for ABC analysis

STEP 2 

List the products in descending order & split the data in A, B and C-articles based on for example A = 70%,  B = 20%, C = 10%

ABC analysis overview

In this particular example the drilling machine and workbench have the highest impact on the company's margin. Making sure enough inventory is available to meet customers demand is very important for these items.

7. Does an ABC analysis give you the right results?

If we look at above example of an ABC analysis, we can see that the first two articles have the biggest impact on the margin of the company. The nails and bolts contribute muchnless to the margin. The reason why an ABC classification is performed, is to make sure each item receives a weighed treatment corresponding to the classification. Although an ABC analysis gives you a good indication of important articles, a proper classification requires to be performed on multiple criteria. Often companies look at the following combination of criteria:

-          Margin/sales & order lines

-       Margin/sales & order quantity

-          Margin/sales & demand pattern

-          Etc.

If it is desired to classify items based on two criteria a so called ABC - XYZ analysis can be used.

8. The next level: ABC-XYZ analysis

In contrast to an ABC analysis, an ABC - XYZ analysis allows you to use two criteria to determine the importance of an article. Giving much more room to make sure the right articles are classified as important. In the underneath example, the ABC -XYZ analysis is based on sales and order lines. The AX articles are most important to the business, while the CZ articles are of low importance. A reason for choosing order lines instead of quantity could be to exclude incidental buys. Meaning if one customer purchases a large quantity of a particular item once the item does not end up as an AX article.

ABC-XYZ analysis in inventory management

Based on the ABC - XYZ classification companies are also able to differentiate service levels per classification group. The service level of AX products could be higher than CZ products. 

9. The complexity of classifying your products

Creating the classification based on historical data means the sales has actually happend and the data is reliable. But what if you have seasonal items? If there was a peak in demand in the past couple of months because of a heatwave and you classify your products based on these particular months?  Your icecreams will be classified as very important, however these items will not be sold in these high quanities during the rest of the year. So how many months' worth of data and when to perform the analysis exactly is of high importance.

Furthermore lead times of suppliers should be taken into account. If the lead time of an inflatable swimming pool is 4 months and you are making a classification in high season for the upcoming two months, the swimming pool will of course be classified as very important. Resulting in a higher service level and therefore more inventory. But with a lead time of 4 months the inflatable swimming pools will be delivered in autumn...

10. Dynamically classifying products based on future demand

Performing a dynamic ABC classification based on future demand is often a great way to make sure seasonal products or products which show a positive or negative trend get the right service level and focus. Products that are becoming increasingly popular can, at this point in time, still be a BY article. But based on the trend in sales, the forecast clearly indicates that the product will become a fast mover. Therefore the item should have a higher service level and already get more attention to make sure iventory levels are increased to manage the upcoming demand. By dynamically recalculating the product classification, organisations can make sure items receive the right level of attention and have the best corresponding service level based on the demand. 

ABC-XYZ analysis recalculation

Making these type of calculations by hand is undoable. Therefore specialised inventory management software can help organisations to perform the calculations automatically with fixed intervals. An ABC-XYZ analysis allows you to set the best criteria and corresponding service levels for each item based on the company strategy.

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