Improving Your Business is as Easy as ABC (Analysis)

ABC analysis is derived from “The Pareto Principle” also called the 80/20 rule. This principle suggests that 80% of the total output is generated by 20% of the valuable efforts. We can apply this in many ways and learn how we can better plan and improve our business.
When it comes to stock or inventory management, ABC analysis segregates inventory into three categories based on its revenue, cost per item and the amount of stock on hand.
  • A is 20% of stock keeping units (SKU) that make 80% of total revenue
  • B is 30% SKUs that make 15% revenue
  • C is 50% SKUs that make at least 5% revenue
This analysis aims to draw attention to the critical few (A) and not on the trivial many (C). It focuses its inventory control efforts on those items where it will have the most significant effect.
Understanding your sales over a certain period will help you evaluate and segregate which product belongs in which category, A, B, or C. This also will assist in analyzing what to buy, and in what quantity. Inventory optimization is the most crucial reason why ABC inventory analysis is used to organize and segregate the products in the inventory as per their revenue and importance to customer demand.
  • Category A 
    • Smallest inventory/highest quality
    • Reserved for the biggest moneymakers
    • High demand products, products generating the most revenue, or seasonal trend products
  • Category B 
    • Less critical than Category A but more critical than Category C
    • Smaller market product/less in demand
  • Category C
    • Products that will help continually run your business with a fixed and steady income
    • Don’t contribute much value to the business
ABC analysis also can be performed for customer segmentation to understand the market and strategize your business plans. For customers, it is based on three primary metrics: revenue potential, sales revenue and contribution to profit margin.
To implement, create charts based on the three different categories classified above. Once the charts are prepared, compare them, especially the sales revenue and contribution margin charts. Rank your customers and categorize them into A, B and C.
  • Category A – Your most valuable customers. They bring in a lot of revenue and make up a crucial portion of the contribution margin.
  • Category B – These customers are loyal and will spend a good amount of money with you at regular intervals. However, you can never expect them to be spending much at one time.
  • Category C – These customers will turn up occasionally and make a purchase. On the other hand, this also can include frequent customers that make many small purchases.
Every product has a lifespan: launch, growth, maturity and decline. The entire lifespan of the product depends on customer demands. ABC analysis helps a seller analyze the customer demand for a particular category of product and then manage their inventory accordingly.
The ABC analysis of the inventory also brings in much more value to the company when the prices for the products are set strategically. It will enable your company to easily strategize the costs of the products and align them into different categories accordingly. The greater the demand for a product, the more opportunity to increase the prices by the seller.
Several factors can affect a product’s value or importance – item cost, quantity sold and profit margin. The ABC inventory system analysis lets the planners set service levels based on the product classification to meet customer delivery expectations.
  1. Identify what needs to be analyzed. ABC is done to achieve two primary goals – to make sure that the supplier price is as competitive as possible and to increase the cash flow by having the perfect number of items on hand that your customers need.
  2. Collect the data from your inventory. Collect data that is already available. What is your annual spending? Include all the ordering and carrying costs. How old is the inventory?
  3. Sort your inventory in the decreasing order of impact. Rank the items in your inventory by cost – from most to least.
  4. Calculate the accumulated impact. List all items and calculate the cumulative sales impact they had on your business.
  5. Divide your inventory into buying classes. You will have to negotiate your contracts with the suppliers, strategize the product prices, and ensure the availability of valuable products – putting A items first.
  6. Analyze the categories and decide accordingly. The products with the highest revenue generation will remain at the top. There are only ‘vital few’ products that will be moneymakers for you. You need to continually monitor the pricing and the selling performance of the products to make sure their positions are adequate and have not changed.
When it comes to supply chain and warehouse management, ABC inventory analysis is primarily used for the stock cycle counts. Category A products will be counted quarterly, as they are more relevant and valuable. Category B products can be counted twice a year. Category C products can be counted once a year.
Stock cycle counts not only help you analyze your highly valued items, but also helps you understand how frequently they need to be replenished. Reordering depends on the category of products and Kanban visual replenishment is often used as the control.
The lean manufacturing training services at the Michigan Manufacturing Technology Center will provide your company with the necessary tools to eliminate waste and strengthen processes for today and the future. Schedule your free assessment today to get started.
MEET OUR EXPERT: Roger Tomlinson, Lean Program Manager
Tomlinson_R.jpgRoger has been a Program Manager in The Center’s Lean Business Solutions program for over 20 years. He has trained and mentored hundreds of Michigan manufacturers in the entire portfolio of Lean strategies and methods (e.g., Kaizen events, Standardized Work, 5S/Workplace Organization, Value Stream Mapping, Total Productive Maintenance, Culture Change, Team Building, operations management and process re-engineering). In addition to his training and consulting work, Roger has over 20 years of experience in manufacturing management.

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Categories: Continuous Improvement, Supply Chain, The Center