78. ABC Analysis in Inventory
Strategic Inventory Classification for Efficient Resource Allocation and Cost Optimization
What is ABC Analysis in Inventory Management?
ABC analysis is a widely used inventory categorization method that classifies items into three groups—A, B, and C—based on their relative importance, typically defined by annual consumption value (i.e., how much they cost multiplied by how often they are used or sold).
It is derived from the Pareto Principle, or the 80/20 rule, which suggests that a small percentage of items account for a large portion of inventory value. This principle is vital for inventory control because it allows companies to focus their resources on the items that matter most.
The Three Categories Explained
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Category A (High-value, low-volume items):
These are the most valuable products in terms of annual consumption. Typically, they represent:
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10–20% of the total number of items
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70–80% of the inventory value
These items require tight controls, accurate records, regular reordering, and close monitoring.
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Category B (Moderate value, moderate volume):
These items fall in the middle:
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Category C (Low-value, high-volume items):
These items are:
How to Perform ABC Analysis (Step-by-Step)
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Collect Inventory Data
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For each SKU, gather:
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Unit cost or price
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Annual usage quantity
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Calculate Annual Consumption Value for Each Item
Use the formula:
Annual Consumption Value = Unit Cost × Annual Usage Quantity
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Rank Items by Value
Sort all items from highest to lowest based on annual consumption value.
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Calculate the Cumulative Percentage
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Classify Items into A, B, and C
Use cumulative percentage rules to assign each item:
Illustrative Example
| Item | Unit Cost (€) | Annual Usage | Annual Value (€) | Category |
|---|
| A1 | 100 | 1,000 | 100,000 | A |
| A2 | 60 | 1,200 | 72,000 | A |
| B1 | 20 | 2,000 | 40,000 | B |
| C1 | 5 | 5,000 | 25,000 | C |
| C2 | 1 | 10,000 | 10,000 | C |
Why Use ABC Analysis?
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Resource Prioritization: Focus on the SKUs that matter most financially.
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Cost Control: Reduce unnecessary handling and storage of low-value items.
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Inventory Optimization: Align ordering frequency, safety stock, and supplier strategies with the value of items.
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Improved Forecasting Accuracy: High-value items (Category A) get better demand planning.
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Warehouse Efficiency: Allocate space and handling resources more effectively.
Inventory Policies by Category
| Category | Review Frequency | Reordering Policy | Stock Accuracy Needed | Safety Stock Level |
|---|
| A | Daily / Weekly | Just-in-Time, Low MOQ | High (98–100%) | High |
| B | Biweekly / Monthly | Batch Orders | Moderate (90–95%) | Moderate |
| C | Monthly / Quarterly | Bulk Orders | Low (80–90%) | Low |
Benefits of ABC Analysis
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Improves working capital allocation
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Helps reduce inventory carrying cost
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Enhances supplier negotiation strategies
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Enables tiered service levels
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Supports better stock-out prevention for high-priority items
Limitations of ABC Analysis
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Focuses only on monetary value, not:
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Item criticality
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Lead time
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Seasonality
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Needs to be recalculated regularly as data changes
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Doesn't account for demand variability
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Can misclassify important low-cost items if not complemented with other metrics
Advanced ABC Techniques
ABC analysis can be combined with:
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XYZ Analysis: Measures demand predictability
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X = highly predictable
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Y = moderately variable
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Z = highly unpredictable
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VED Analysis: Based on criticality
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FSN Analysis: Based on stock movement speed
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Multi-Criteria ABC: Adds factors like lead time, item criticality, margin, and frequency of use to create a more nuanced classification
Use Cases in Business
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Retailers: Stock optimization and shelf-space management
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Manufacturers: Prioritize raw material purchasing and production planning
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eCommerce: Manage SKUs across multiple fulfillment centers
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Healthcare/Pharma: Control of high-value or temperature-sensitive drugs
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Automotive/Industrial: Spare parts stocking and vendor agreements
Summary
ABC analysis is a strategic, data-driven method that allows businesses to focus inventory efforts where they generate the most financial impact. By categorizing items based on their consumption value, it helps reduce waste, optimize inventory levels, and ensure critical items are always available. However, to be truly effective, ABC analysis should be part of a broader inventory management strategy, supported by frequent updates, advanced analytics, and integration with other classification models.
