FinancialManagementPro.com

ABC Analysis of Inventory

By Yuriy Smirnov Ph.D.

Definition

ABC analysis is a technique of categorization based on the Pareto principle. This technique is used in inventory management to categorize inventory in terms of annual consumption value to assign the most valuable items. The categorization criteria of ABC analysis are as follows:

Such a method helps inventory managers focus their efforts on the most important inventory items by type, avoiding wasting time to control items of low significance.

Pareto principle

The ABC Analysis is based on the Pareto principle (also called the 80/20 rule), which states that about 80% of the effects come from about 20% of the causes. In terms of inventory management, the Pareto principle can be declared as 20% of inventory items by type account for 80% of annual consumption value. This relationship is shown in the figure below.

ABC analysis and Pareto principle

How to categorize inventory items

Segregating inventory items into categories A, B, and C is quite arbitrary in ABC analysis but can be done in several ways.

Empirical method

This technique is the most popular due to its simplicity. The splitting criteria are as follows:

Please note that these splitting criteria may vary to some extent, e.g., category A may comprise 70% of annual consumption value and 25% of inventory items by type, or category B may represent 20% of annual consumption value and 35% of inventory items by type.

Sum method

Applying the sum method to segregate inventory items involves two metrics:

  1. Percentage of annual consumption
  2. Percentage of inventory items by type

Please note! Each inventory item by type has the same proportion. It does not matter how much items are comprised by each type of inventory, e.g., if a business has 25 types of inventory items, the percentage of each will be 4% or 1/25.

The idea behind the sum method is to use the sum of two metrics above to categorize inventory items. The splitting criteria are as follows:

Tangent method

The tangent method is rarely used in ABC analysis. It is a graphical method and involves using a Pareto diagram.

ABC analysis under tangent method

We should perform several steps to categorize inventory items.

  1. Draw the line connecting the beginning (point “K”) and the end (point “L”) of a Pareto curve.
  2. Draw the parallel line to the line “KL,” which is tangent to the Pareto curve. The point of tangency “A” is a border of category A.
  3. Draw the line “AL.”
  4. Draw the parallel line to the line “AL,” which is tangent to the Pareto curve. The point of tangency “B” is a border of category B.
  5. All the inventory items to the right of point “B” belong to category C.

Conclusions

Please note that using each of these techniques in ABC analysis will result in a slightly different categorization of inventory items. The empirical method is preferable in ABC analysis to the other two because sales or procurement volume is not the only metric that determines the importance of an inventory item. So, the sales or procurement manager should also take into account other conditions when segregating inventory items by category.

Example of ABC analysis

The table below contains an example of the ABC analysis of inventory.

Example of ABC analysis

To obtain the results of ABC analysis as in the table above, we should do as follows:

  1. Rank inventory items by type in descending order of their annual consumption value, i.e., most valuable inventory goes first and least valuable inventory goes last.
  2. Calculate the percentage share of each inventory item by type in total annual consumption value, e.g., percentage share of Item 1 equals 19.84% ($5,750,000 ÷ $28,975,000) and percentage share of Item 2 is 17.08% ($4,950,000 ÷ $28,975,000).
  3. Calculate cumulative percentage share.
  4. Segregate inventory items by type in categories A, B, and C.

The inventories in the table above were categorized under the empirical method as follows:

Let’s draw a Pareto diagram using the data above.

Example of ABC analysis

Let’s split the inventory items using the sum method. The results of ABC analysis are as follows:

Example of ABC analysis

*Cumulative percentage share is the sum of percentage share in annual consumption and percentage share in inventory items by type.

The categorization of inventory items under the sum method is as follows:

If ABC analysis is made under the sum method, the Pareto diagram is as follows:

Example of ABC analysis

Advantages and disadvantages of ABC analysis

Advantages

The advantages of ABC analysis are as follows:

  1. Decrease in working capital needs. Categorization of inventory items enables the inventory manager to focus on those that are most valuable. The optimization of category A items helps reduce current assets and therefore decrease working capital needs.
  2. Better inventory control. Concentration of effort on the most valuable items allows inventory control to be improved with a minimal increase in cost. It also helps avoid overstocking or inventory shortage.
  3. Cost reduction. Optimization of inventory results in a decrease of ordering and holding costs and losses due to inventory shortage. In turn, a decrease in working capital needs allows a reduction in interest expense.

Disadvantages

  1. Ignoring most factors. ABC analysis assumes using the metric only for inventory items categorization and namely annual consumption value. Any other factors are not taken into account.
  2. Arbitrary categorization of inventory items. The empirical method of inventory categorization does not set strict category boundaries and depends on the inventory manager’s professional judgment. Therefore, the efficiency of ABC analysis may be less due to incorrect judgment.
  3. Limitation in use for some businesses. ABC analysis can’t be used by businesses that have a quite equable annual consumption value of inventory items by type. In such cases, it becomes impossible to segregate inventory items using the Pareto principle.
  4. Сomplicacy. If a business has a large number of inventory items, application of ABC analysis requires considerable effort to reflect increased inventory management cost, e.g., a business will have to hire additional staff or buy special equipment to control inventory.