ABC analysis is a method that entails categorizing items based on their perceived value and is used in inventory management. It helps companies identify the most valuable products that match customer demand, control and allocate resources efficiently, reduce obsolete inventory, and increase sales.

Watch the video below to uncover how ABC analysis works.

We will discuss an inventory categorization method based on the Pareto principle also called the 80/20 rule. According to this principle, 20% of main goods represent 80% of sales volume. In this article, we’ll review the use of ABC analysis, explore its advantages and disadvantages, and check out 6 steps to conduct ABC analysis.

What is the use of ABC analysis?

ABC analysis enables businesses to figure out how to manage their inventory properly based on the key metrics. To find out whether customers will buy a certain product, a brand needs to understand customer demand. Companies that opt for ABC analysis have a chance to analyze the demand and manage their inventory based on this data.

One more reason businesses use ABC analysis is stock optimization. To meet customer needs, obtain great sales volume, and high profit, a company should categorize products based on demand, importance, and profit they can make. With the received information in mind, business owners can set prices for their products or services strategically.

ABC analysis helps identify and reduce the number of products customers don’t like or those with a low profit margin. After the method is implemented, entrepreneurs obtain a smoother supply chain, reduce costs on additional stock, and allocate resources efficiently.

Now that you know the use of ABC analysis, we’ll proceed to the pros and cons of this technique.

Advantages and Disadvantages of ABC Analysis

By evaluating inventory and classifying it under the principles of ABC analysis, companies can identify the areas of manufacturing or sales that bring in the most value. The main advantage of the technique is that it helps identify goods consumers buy most often and monitor availability to avoid stockout. So, businesses can focus on high-priority products that bring good ROI.

One more advantage of this method is the efficient allocation of resources. With ABC analysis, you can spend more money on purchasing goods popular among customers and ultimately bring good profit to your company. Moreover, it enables you to reduce costs on items that bring little or no profit and just gather dust on the shelves of your warehouse.

The disadvantages of the method include conflicts with traditional costing systems and substantial costs. Routine analysis of high-priority products requires higher expenses, that’s why a company should prepare some extra costs.

The pros and cons are clear now, so let’s figure out how to organize the process.

6 Steps to Conduct ABC Analysis

To do an effective ABC analysis, you need to follow a certain sequence of actions. We’ve prepared 6 steps for you to consider when implementing this method into your business strategy. Stick to these steps to conduct a successful analysis.

  1. Define the things you want to analyze. The main goal of ABC analysis is to determine the importance of each product. The method enables you to identify the most and least profitable items. As a result, you’ll be able to improve the financial performance of your company. That’s why think of the items you need to analyze to understand their value for consumers and the profit they bring.
  2. Gather necessary information. Once you define the inventory to analyze, collect information about ordering and carrying costs. Leverage one of your accounting tools to obtain this data.
  3. Sort your goods. Before diving into the process, sort your products based on their cost. Rank them from the most expensive to the cheapest ones.
  4. Figure out the impact of products on your company. List down the products in a spreadsheet and find out the influence each of them has on your business. Divide the goods and their annual costs.
  5. Divide products into three classes based on demand. Now it’s time to split up your goods into classes based on the main principle of ABC analysis. Divide your products into three classes: A — most valuable products that bring 80% of profit, category B — less popular and valuable products that bring 15%, and C — items that bring 5% of revenue.
  6. Analyze the obtained data. In the end, you’ll have a spreadsheet with items that generate the most revenue and those that aren’t popular with buyers. Check out the list to find the money makers at the top. Once you obtain the necessary information about high priority and low priority products, use it to your advantage. Bear in mind that you still need to track the pricing and the selling performance of the goods to ensure that their positions don’t fluctuate.

In a nutshell, the technique is especially useful in warehouse management to identify the items that bring the highest profit and products that a business owner doesn’t need to replenish. The analysis gives business owners a clear picture of the sales performance of certain goods.

Resources:

  1. This article defines the term, contains examples of ABC analysis, and a guide.
  2. In this article, you’ll find the advantages and disadvantages of ABC analysis.
  3. This article uncovers 8 steps of ABC analysis.
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