Inventory ABC Analysis Explained: Calculation and Example

Did you know? United States retailers hold about $1.39 in inventory for every dollar of sales. With such significant amounts tied up in inventory, businesses face the constant challenge of balancing and maintaining optimal stock levels and avoiding the risks associated with dead stock.

If done wrong, inventory management can break a business. One method gaining traction for effective inventory management is ABC analysis.

But what is this method about? How does it help businesses optimize investment and increase profitability? 

​Let’s find the answers in the article below!

Introduction to ABC Analysis in Inventory Management

ABC analysis, also known as ABC classification, is an inventory categorization technique that classifies inventory products based on their relative importance in the portfolio. It classifies the inventory into three distinct categories: A, B, and C. Here, Category A represents the most valuable items, and Category C represents the least valuable. 

This classification allows businesses to prioritize their resources and attention, focusing on the items that have the most significant impact on revenue and profitability while optimizing inventory management practices.

Breaking Down the ABCs: Understanding A, B, and C Categories

ABC analysis is based on The Pareto Principle, also called the 80/20 rule. According to this rule, 80% of the effects come from 20% of the causes. In inventory management, approximately 80% of a company’s sales typically come from only 20% of its products.

This principle forms the basis of ABC analysis, categorising inventory items into three main groups: A, B, and C. 

Let’s discuss each category to understand its significance:

• Category ‘A’ Items: These high-value items contribute significantly to a company’s revenue stream. Around 20% of inventory items typically fall into this category, representing approximately 80% of total sales revenue. Examples may include top-selling products, high-demand items, or those with high profit margins.

• Category ‘B’ Items: Items in this category are moderately important. They contribute to the overall sales volume but are not as critical as Category A items. Category B items represent about 30% of inventory and contribute around 15% of total sales revenue. While they may not drive revenue as significantly as Category A items, they still play a vital role in the company’s overall performance. 

• Category ‘C’ Items: These low-value items have minimal impact on revenue. Although they comprise the majority of inventory items, representing roughly 50% to 60% of the total, they contribute only a small percentage to the overall sales revenue, typically around 5% to 10%. These items may include slow-moving inventory, seasonal products, or low-demand items.

By applying the Pareto principle via ABC Analysis, businesses can continually:

• prioritize their focus on high-revenue-generating items (‘A’ category), 
• balance resources with moderate-value items (‘B’ category), 
• and reduce excess inventory costs associated with low-value (‘C’ category) stocks.

Organizations can significantly improve their inventory efficiency and profit potential through this blend of ABC Analysis and the Pareto Principle.

Benefits of ABC Analysis in Inventory Management 

Deciding which products to procure to meet future demand without accumulating excess stock is complex. Similarly, mindlessly purchasing or relying on intuition often leads to acquiring products that fail to align with customer demand.

Furthermore, stockouts of popular items can result in lost sales opportunities, as disappointed customers may turn to competitors. In the United States and Canada alone, retailers collectively lost approximately $349 billion in 2022 due to inventory distortions, such as stockouts and overstocks.

ABC analysis is an effective method for inventory management. It offers the following benefits to businesses. 

• Optimal Resource Allocation: ABC analysis enables businesses to allocate resources effectively by prioritizing attention and resources towards high-value items (Category A) contributing to revenue. By focusing on these critical items, companies can ensure their most valuable assets receive prioritized attention.

• Enhanced Forecasting Accuracy: ABC analysis provides valuable insights into the demand patterns of different inventory items. Businesses can improve forecasting accuracy and inventory replenishment strategies by understanding which items are most crucial to their operations. This helps minimize stock outs for high-demand items while avoiding overstocking low-demand items. 

• Better Supplier Negotiations: Businesses can negotiate more effectively with suppliers when they clearly understand the importance of each inventory item. Companies can secure better pricing, terms, and discounts from suppliers by focusing on high-value items (Category A) and leveraging economies of scale.

• Improved Profitability: Ultimately, the primary goal of ABC analysis is to improve profitability. By focusing on high-value items and optimizing inventory levels, businesses can increase sales revenue, reduce holding costs, and improve operational efficiency. This results in higher profit margins and a healthier bottom line for the company.

A Step-by-Step Guide to Performing ABC Analysis

Performing an ABC analysis of inventory doesn’t need to be overwhelming. It’s a straightforward process that anyone can undertake by following a structured approach.

Example Scenario:

For example, let’s consider a brand specializing in baby food products. We will categorize the products based on the following criteria:

• A-Items (20%): These are the top-selling products that drive the majority of sales. They include premium infant formulas, specialty organic baby foods, and hypoallergenic options. Despite their potentially higher price points, these items enjoy consistent demand and significantly contribute to overall revenue.

• B-Items (30%): This category comprises stage-specific baby foods, such as purees, cereals, and snacks. While not as high in demand as A-Items, they cater to a broader range of needs and budgets, making them crucial for attracting and retaining customers.

• C-Items (50%): Accessories like baby feeding utensils, bibs, and food storage containers fall into this category. Although these items may not drive substantial sales individually, they enhance the overall customer experience and complement core baby food products.

In the following steps, we will explore how to perform an ABC analysis effectively, using the outlined example to illustrate each stage of the process.

Step 1 – Gather Data

Having the correct data, i.e., key information for each product in your inventory, is crucial for effectively initiating the ABC inventory management process.

Collect Unit Cost and Selling Price

Start by gathering data on the unit cost and selling price of each product. This information forms the basis for determining the financial value of your inventory items. Here’s a simplified table representing the unit cost and selling price for products on our baby food e-commerce website:

Gather Annual Sales Volume and Value

Next, collect data on the annual sales volume and value of each product. This information provides insights into the demand and revenue generated by each item over a specific period. 

The table below shows 3 months of order history. 

Step 2 – Calculate Metrics

Once you have compiled the data, calculate the annual sales value, percentage of items sold, and percentage of total inventory.

Here’s how to calculate these figures.

Annual Sales Value

Calculate the annual sales value of each product by multiplying the unit selling price by the corresponding annual sales volume for each item. 

Formula: Annual Sales Value = Unit Selling Price × Annual Sales Volume

Percentage of Total Sales

Determine the percentage of total sales revenue contributed by each product.

[TotalAmount]*100/SUM([TotalAmount]) over (partition by [Year])

Percentage of Total Inventory

Calculate the percentage of total inventory value represented by each item. This metric offers insights into the relative value of products within your inventory.

Formula: Percentage of Total Inventory = (Annual Sales Value / Total Inventory Value) × 100

Step 3 – Rank the Items

Once you’ve calculated the essential metrics for each product, rank them based on their annual sales value. Arrange all items in your inventory in descending order, listing products from highest to lowest based on the revenue they generate annually.  

ROW_NUMBER() OVER (partition by [Year] order by [TotalAmount] desc)

Step 4 – Calculate Cumulative Metrics

Once you have ranked items according to their annual sales value, calculate cumulative metrics to better understand their collective impact on sales revenue and inventory value.

Cumulative Percentage of Total Sales

Calculate the cumulative percentage of total sales revenue contributed by each item. This metric highlights the cumulative contribution of items in driving overall sales revenue.

SUM([PercentageTotalYearSales]) over (partition by [Year] order by [Ranking] asc)

Cumulative Percentage of Total Inventory

Similarly, compute the cumulative percentage of total inventory value as you move down the ranked list of items.

Calculating these cumulative percentages helps understand where most of the income sources are, which is crucial for identifying thresholds later. 

SUM([PercentageTotalYearInventory]) over (partition by [Year] order by [Ranking] asc)

Step 5 – Identify Thresholds

You can now identify thresholds using the cumulative proportional percentages calculated in the previous step. These will help you classify each product into the appropriate classification (‘A’, ‘B’, or ‘C’).

The table below displays the percentage of total sales revenue and percentage of total inventory value (% stock) for each product.

Step 6 – Assign Categories

With the thresholds defined in the previous step, categorize each product into the appropriate classification (‘A’, ‘B’, or ‘C’). These categories help prioritize inventory management efforts and resource allocation.

• ‘A’ Category: High-value items driving substantial sales revenue receive top priority.
• ‘B’ Category: Moderate importance products contributing to revenue and inventory value.
• ‘C’ Category: Lower-priority items with lesser individual significance but collective value.

Consider the following categorization based on the defined thresholds:

Step 7 – Review and Adjust

Performing inventory ABC analysis is an ongoing process. After categorization, reviewing outcomes and making necessary adjustments regularly is crucial.

Follow these steps to ensure efficient stock management practices:

• Regularly review categorizations to ensure they align with the latest business insights and market dynamics.
• Adjust categorizations based on factors like seasonality changes or sudden shifts in market scenarios that influence product performance.
• Maintain periodically updated inventories to ensure accuracy and relevance over time, reflecting dynamic business needs.
• By keeping inventories up-to-date, preserve accuracy and effectiveness in stock management practices.
• Businesses facing seasonality or rapidly evolving demand should establish specific rules and review the ABC analysis more frequently to accommodate changing conditions.

ABC Analysis Use Cases

ABC Analysis for Warehouse Optimization

Distributors can use ABC analysis for the physical optimization of warehouses. For instance, a distributor can organize items in a warehouse based on how quickly they sell. The fast-moving or frequently sold items are categorized as ‘A’ and placed where they’re easy to reach, cutting down on the time and effort needed to handle them. 

On the other hand, items with less movement frequency are categorized as ‘B’ or ‘C’ based on their importance level. This method makes warehouse inventory management more efficient, smooths operations, and reduces errors. 

ABC Analysis for Production Procurement 

Manufacturers can use ABC analysis to streamline production processes and increase profit margins by classifying products by revenue. 

For instance, a manufacturing company can categorize raw materials based on usage frequency and cost. Critical raw materials essential for manufacturing products are classified as ‘A’ items, whereas less expensive or low-usage materials are categorized as ‘B’ or ‘C’.

This enables the company to prioritize procurement efforts, ensuring that essential materials are always available without overstocking less critical items.

Automate Your ABC Analysis and Inventory Management With ClicData

While the traditional manual method of performing ABC analysis has benefits, it can be time-consuming and prone to errors. Automated tools like ClicData can simplify inventory management tasks. 

ClicData is a powerful data management and analytics platform that easily automates your ABC Analysis procedure. It improves accuracy and accelerates the process, enhancing inventory control and saving time and money. 

• Quick Data Integration: Through ClicData, you can aggregate data from multiple sources, including your warehouse system or any eCommerce interface(s) you use.

• Automated Calculation: Instead of manually calculating values like the annual usage value for each SKU (Stock Keeping Unit), ClicData performs this operation automatically, significantly reducing the risk of human error.

• Efficient Ranking & Assignment: After the calculations are done, ClicData ranks the items from highest to lowest according to their usage value. It then categorizes them into A, B, or C groups based on preset thresholds.

• Dynamic Updates: As market dynamics evolve, so does the demand for your products. Therefore, regular updates to your ABC analysis are crucial. This task can be exhausting if done manually, but using an automated system like ClicData makes it remarkably simplified.

By leveraging advanced technology like ClicData, you can make informed decisions regarding stock levels and reorder points across different inventory categories. Brands with diverse SKU ranges benefit significantly from adopting such software. From optimizing safety stock levels to more efficiently addressing out-of-stock and deadstock challenges, automated ABC analysis offers a smart solution.