ABC Analysis is a categorization technique that places different levels of significance on a range of items to help you prioritize effectively. The analysis states that according to their respective levels, these items should be handled or controlled differently. ABC Analysis is known as a way to best analyze and manage inventory. Yet, the items that you categorize can include activities, customers, documents, sales territories, and more, making it a very flexible tool.
Overall, ABC Analysis is a helpful business practice to know, as it can be applied to almost any firm.
Steps in the ABC Analysis
The ABC Analysis method is relatively straightforward, and the steps are as follows:
- Create an exhaustive list of all the items you are analyzing
- Create an objective criteria that you can use to rank your items
- Group the items into three categories (A, B, C) in order of their estimated importance
- ‘A’ items are very important
- ‘B’ items are important
- ‘C’ items are marginally important
You can see that the ABC Analysis steps are easy to understand, but using this simple tool can garner big benefits. Let’s look at that next.
Objective and Benefits of ABC Analysis
The objective of ABC Analysis is to help businesses determine where to best utilize resources to optimize results. ABC Analysis is based upon the principle that items that fall in the same category (inventory, customers, documents, etc.) do not each hold equal value. This is similar to a popular consulting concept known as the Pareto Principle (also known as the 80/20 rule), which states that for many events, roughly 80% of the output come from just 20% of inputs. In the same way, the ABC Analysis method helps companies see where they may derive the most benefit.
The main benefit of ABC Analysis is business efficiency. By using this method, a business is able to focus on the components that drive the most value. Ultimately, this leads either to higher sales, lower costs, or both. These days, businesses have large amounts of operational data at their disposal. This can be overwhelming if you don’t have a strategy for analysis. ABC analysis is a great way to quickly focus on what you know is most important. Once the data is segmented into different parts, it’s often easier to derive deeper insights from that smaller subset.
ABC Analysis Example
Let’s take a look at an example of ABC Analysis in use to really understand its benefit. Imagine that you own a shoe manufacturing company that is currently facing an inventory problem. Your warehouse is stocked with far too many shoes of various types and you need to figure out how to best reduce inventory.
Using the ABC Analysis, you gather all relevant historical sales data for your shoes. You discover the following:
- The ‘A’ shoes account for 20% of inventory and drive 70% of sales volume
- Your ‘B’ shoes account for 30% of inventory and drive 20% of sales volume
- And finally, your ‘C’ shoes account for 50% of shoes and drive 10% of sales volume
Using the ABC Analysis on your inventory, you realize that the majority of your focus should be on the ‘A’ shoes. As a result, you decide to put the majority of your resources (purchasing, marketing, etc.) into the ‘A’ shoes and increasingly less to your ‘B’ and ‘C’ shoes. Segmenting the raw data by sales volume helped you determine this strategy.
For example, if you were ordering the same number of shoes on a recurring basis across all shoe types, you would eventually be left with way too many ‘B’ and ‘C’ shoes. Instead, it would be much wiser to order more in the ‘A’ category, provided you haven’t fully saturated the market. This is important not just from a sales perspective but also for other related costs. Having extra inventory results in additional storage and labor costs.
ABC Analysis is a great way to strategically organize large heaps of data in a business and create plans of action. In this way, it’s easy to see how the objectives of ABC Analysis are ones that every business aspires to. There is no hard and fast way to use the method; instead, think of it as a general guideline. Over time and continual use, ABC Analysis provides a valuable way for a company to maximize its profits and improve the efficiency of its operations.