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Inventory Management / Optimisation
Inventory Management / Optimisation
13 min read

Unlock Strategic Inventory Management with ABC Analysis: Insights, Formulas and Tips

Published on:
May 28, 2024

Everywhere you look, you’ll find the Pareto Principle — also known as the 80/20 rule. 20% of minerals make up 80% of the Earth’s crust, 20% of species are responsible for 80% of the world’s biomass, and in business, 20% of customers generate 80% of profits. The question is, do you know which 20% of your wholesale inventory is driving 80% of your revenue? If not, it’s time to think about ABC analysis.

ABC analysis is a simple but powerful technique that categorises items into three groups — A, B, and C — based on their value and impact on overall costs. It plays a central role in strategic inventory management by allowing you to prioritise resources efficiently. In short, understanding what matters most in your inventory helps you make more informed decisions, reduce risk, lower costs, and increase your market responsiveness.

Ready to streamline your inventory strategy to boost financial performance and competitiveness? Read on to discover essential insights, formulas, and practical tips for effective ABC analysis.

Why does ABC analysis matter?

To help you focus on the most important items and balance cost control with service excellence, ABC analysis sorts your inventory into three basic categories.

  • Category A: These are your high-value items, making up about 20% of your inventory but accounting for 70-80% of its value. Due to their significant impact on financial performance, these items require close monitoring and careful management.
  • Category B: These items are of moderate value, comprising around 30% of your inventory and representing 15-25% of its value. They are monitored more frequently than Category C items but less so than Category A.
  • Category C: The least valuable, these items constitute the bulk of your inventory — about 50% — yet they contribute only 5-10% of the value. Management of these items can be less intensive.

Here are just some of the ways ABC analysis can benefit your wholesale business.

  • Streamlined costs: Different management strategies for A, B, and C items optimises costs, monitoring A items closely and buying C items in bulk.
  • Better use of resources: Focused management ensures high-value items are always available, preventing stockouts.
  • Higher efficiency: Clear item prioritisation improves operational efficiency and order response times.
  • Smarter decision-making: ABC analysis helps you make informed choices about pricing, purchasing, and sales to manage stock levels more effectively.
  • Lower risks: Pinpointing key items reduces the chance of over- or understocking.
  • Greater flexibility: Item prioritisation lets you more quickly adjust to demand changes or supply chain issues, maintaining your service levels.

While single factor ABC analysis is a great start, more advanced Double ABC analysis takes these benefits even further. It gives you deeper insights into item importance and enables more refined inventory control by categorising products based on two key metrics.

Key ABC analysis parameters

Based on your needs and business objectives, you can apply a wide range of different parameters to determine the relative importance of items during ABC analysis. Here are some to consider.

  • Cost of goods sold: Assesses the financial impact of items, with those higher ranked needing tighter control.
  • Margin: Focuses on profitability per item to prioritise those offering higher returns.
  • Sales turnover: Identifies fast-moving items to keep up sales momentum.
  • Sales quantity: Important in retail, this classifies items based on their revenue contribution.
  • Most frequently sold: Classify inventory according to the most frequently sold items, regardless of the number of items sold in each transaction.
  • Demand variability: Identifies items with high variability that require close management to avoid stockouts.
  • Lead time: Highlights items that are essential to production or sales and require close management to avoid supply disruptions.
  • Stock-out impact: Looks at how item shortages affect operations and customer satisfaction.
  • Unit cost: Ranks items by tying up capital based on cost per unit. Important for items that are costly but sold less frequently.

To tailor your inventory management strategy effectively, it's essential to select the most appropriate ABC parameters for your specific business needs. For instance, a wholesaler specialising in highly seasonal goods might prioritise demand variability to manage fluctuations efficiently, while another one dealing with luxury items could focus on unit cost to ensure capital isn't tied up in slow-moving stock. More sophisticated Double ABC analysis also lets you apply two parameters simultaneously, such as turnover and order frequency, to prioritise items that are crucial for maintaining profitability and high service levels.

Formulas for ABC analysis

Based on the parameters you’ve chosen to apply in your ABC analysis, various formulas can help you sort items by importance or value. Let’s use the formula for cost of goods sold as an example, which evaluates an item's financial impact on your wholesale business to inform an ABC ranking.

Annual Consumption Value = Annual Sales × Cost Per Unit

Here, Annual Salesis the total quantity of the item used or sold over a year and the Cost Per Unit is the purchase cost of each unit. After ranking items by annual consumption value, determine the cumulative inventory value they represent to categorise them into A, B, or C groups.

For instance, let’s say your clothing wholesale business has the following data for three items.

Designer shirts: 100 units used annually, $50 per unit.

Generic shirts: 300 units used annually, $15 per unit.

T-shirts: 600 units used annually, $5 per unit.

First, calculate the annual consumption value.

Designer shirts: 100×$50=$5,000

Generic shirts: 300×$15=$4,500

T-shirts: 600×$5=$3,000

Next, rank these items by their consumption values and calculate the cumulative percentage of total value.

Total value = $5,000 + $4,500 + $3,000 = $12,500

Cumulative for Item 1 = $5,000/$12,500 × 100 = 40

Cumulative for Item 1 and Item 2 = ($5,000 + $4,500)/$12,500 × 100 = 76

Cumulative for all items = ($5,000 + $4,500 + $3,000)/$12,500 × 100 = 100

At the end of your calculation, designer shirts would be classified as 'A' items due to their high value contribution, generic shirts as 'B' items, and T-shirts as 'C' items.

Common challenges in ABC analysis

Implementing ABC analysis to classify your inventory brings significant benefits, but it isn’t always smooth sailing. Here are some frequent challenges wholesalers face.

  • Data quality and availability: Effective ABC analysis depends on accurate, comprehensive data. Poor data quality can lead to misclassification and inefficiencies.
  • Choosing the right criteria: It's vital to select the most appropriate criteria for categorising inventory to ensure alignment with your strategic business goals.
  • Resistance to change: Introducing a new inventory classification system often encounters resistance from employees used to existing processes.
  • Continuous maintenance: ABC analysis requires regular updates to stay relevant, demanding ongoing attention and resources.
  • Integration with existing systems: Integrating ABC analysis into existing systems can be technically challenging and costly.
  • Training and expertise: Effective implementation of ABC analysis requires adequate training and expertise, or adoption may be hindered.
  • Balancing complexity and usability: ABC analysis must balance analytical depth with practical usability to simplify rather than complicate inventory management.

Tips for effective ABC analysis

Here are some practical ways to implement ABC analysis effectively and optimise your approach.

  • Set the right strategy:

    • Define your objectives: Start with clear goals for what ABC analysis should achieve, such as reducing carrying costs or optimising stock levels.
    • Select appropriate criteria: Choose ABC criteria reflecting strategic priorities, considering factors like lead time, supply risk, and criticality to production.
    • Set clear inventory control policies: Apply different management policies to each category, with A items requiring more frequent reviews and tighter reorder points.
    • Supplier collaboration: Enhance relationships with suppliers, especially for A category items, to secure better terms and ensure high service levels.
  • Deploy slowly and carefully:

    • Implement gradually: Start with a pilot programme to fine-tune the ABC process based on initial feedback before full implementation.
    • Monitor performance and adjust: Continuously assess inventory management performance using key performance indicators to identify improvement areas.
    • Seek expert advice: Consult with experts for tailored insights and guidance on optimising the ABC classification process.
  • Ensure accurate data and categorisation:

    • Data accuracy: Maintaining up-to-date and accurate data on inventory levels, costs, and usage rates is essential for effective categorisation and management.
    • Dynamic categorisation: Regularly review and update ABC classifications to adapt to changes in market conditions and business priorities.
    • Apply double ABC analysis: A more nuanced and powerful approach, Double ABC analysis integrates two distinct parameters instead of just one. This allows for more refined item categorisation based on deeper insights into inventory dynamics. As a more adaptable technique, Double ABC analysis is especially useful in complex business environments.
  • Leverage technology:

    • Automate ABC analysis: Use modern inventory management software for improved accuracy and efficiency in the ABC process.
    • Automate monitoring and reordering: Use inventory management software or ERP systems to closely observe inventory levels, especially for A and B items.
    • Integrate with wider business systems: Incorporate ABC analysis into broader business systems for aligned and efficient operations.
  • Manage your team and training:

    • Communicate changes and benefits: Maintain open communication with all stakeholders to ensure support and cooperation across the organisation.
    • Cross-functional involvement: Engage various departments to ensure balanced and strategic inventory decisions.
    • Train your team: Provide comprehensive training to ensure all relevant team members understand and can effectively utilise ABC analysis.

We can help!

With insights from effective ABC analysis, you can optimise inventory management, streamline costs, boost profitability, and respond faster to the market. You’ll also be more competitive, thanks to the ability to foresee problems and make informed decisions more quickly.

Fast to implement, easy-to-use, and highly scalable — our cloud-based inventory management software has everything you need to focus on the highest-performing items and bring your supply chain to the next level. As well as enabling process automation and simple integration with existing systems, our software’s monthly ABC calculations can identify the high-value, fast-moving items that have the biggest impact on your bottom line and customer satisfaction.

Learn more about how we can help or book a personalised demo.