ABC Analysis (80/20 Rule) in Inventory Management
ABC analysis helps manufacturers get insight into their supply chain, reduce inventory, and improve inventory management. And it does not require a data analyst nor a substantial amount of resources to do it right.
What is ABC analysis?
ABC analysis is a categorization technique used in inventory management.
The technique is based on the Pareto principle (or 80/20 rule), which states that 80% of the consequences originate from 20% of the causes, meaning that the relationship between inputs and outputs is unequal.
By applying this principle to inventory management, we find that a small variety (20%) of stock-keeping units comprise most (80%) of the total consumption value (or sales revenue in case you need to apply the analysis to final products).
Knowing which SKUs make up most of your business allows you to set priorities for the items before negotiating prices with suppliers, determining service levels and safety stocks, or assigning workers to tasks like inventory review.
How to conduct an ABC analysis
You can use ABC analysis to divide your SKUs into three categories:
- A-class items are few in numbers (around 20%) but have the highest consumption value (ca. 80% altogether).
- C-class items are many in numbers (about 50%) but have a low consumption value (ca. 5% altogether).
- B-class items fall between the two aforementioned categories (making up about 30% of the items with around 15% of the consumption value).
It is strongly recommended to use consumption value or revenue generated by an SKU to measure its value, not its quantity, because quantity is often not a great indicator of business value. Use an SKU’s quantity only when physically organizing your inventory (see a chapter about it below).
An item’s consumption value can be calculated by taking the item’s cost per unit and multiplying it by its quantity used during a set period, preferably a year.
You can also easily find all your items’ yearly consumption values in your MRP software by going to the Stock -> Stock movement section, setting the period as “Last 12 months”, then clicking on the “Used in manufacturing” sum in the Outward section, selecting the “Sum per stock item” view and looking at the Cost column for each article.
In order not to over-complicate the example, we are using a very small number of products and consumption for calculations.
You can, however, use ABC analysis for inventory management in a business of any scale.
Find the percentage by dividing the item’s yearly consumption value by the total yearly inventory consumption value and multiplying the result by 100.
Now add up the percentages starting from the largest.
When you reach the cumulative 80%, set a cap. The items making up the 80% belong to the A category.
Then start again with the next items to get the 15% for the B category, and then 5% for the C category.
Approximations are absolutely fine if you cannot reach a perfectly round cumulative percentage.
How to use ABC analysis
Now, as your inventory is categorized by the value of the SKUs, it is time to put it into use.
Take a look at how you have managed your inventory so far.
Do you keep the same amount of stock regardless of the article?
Do you apply the same purchasing policies to all items?
Do you spend an equal amount of time reviewing all SKUs?
If any of your answers to these questions was “yes”, you can put the analysis to good use right away.
Start by rethinking your purchasing and inventory policies according to the priorities set, giving more attention to A and B-category SKUs, and less to C-category items.
A-category items should receive:
- Higher service levels
- More review time per item
- More attention when negotiating prices and lead times with the suppliers
- More resources allocated for them in general
B-category items should receive less attention than A-class items, but should not be overlooked.
C category items should receive the least amount of attention, in fact, many of the processes related to C items may be automated.
You can also assign separate KPIs and reporting practices to different classes in order to get better insight into their performance.
For example, A class items could be assigned a monthly review while C class items would be reviewed once every six months.
By doing all that, you could substantially cut down on inventory, reduce holding costs, prevent stock-outs and overstocking, develop a more reliable cycle time, and keep customers happy.
It is recommended to re-analyze your inventory at least once a year, as regular re-analysis can help you track changes in SKU performance and act accordingly by reassigning them to another category.
Read more about SKUs from Stock Keeping Unit (SKU) – Best Practices for Inventory Classification
ABC analysis: Things to keep in mind
Although ABC analysis is seemingly very easy to conduct and provides plenty of benefits, it has its limitations.
- Its stability depends on the stability of your items’ performance. Be prepared for a portion of your SKUs to be reclassified each time you review the analysis.
- To use it, you are going to need reliable historical cost and demand data by item. That means in case new items enter your inventory, you can reliably categorize them only after a while.
- It is stationary, which means it does not account for consumption patterns like seasonality for example.
- It might leave SKUs that are rarely consumed yet are still crucial to your business without the necessary attention.
One of the greatest weaknesses of ABC analysis is that it employs only one parameter – value – and does not account for fluctuations in consumption.
For example, if you have items that are consumed by huge quantities at a time but very irregularly, then by using the ABC method, you could classify them as A class articles.
But due to them being used periodically, having a large amount of them in inventory at all times would be unfeasible.
More so, it would be detrimental to business due to elevated holding costs, and possible damaging or perishing of the goods.
On the other hand, having an item with low but constant demand would be classified as a C article.
A stable demand, however, requires constant attention.
That means we are going to need to account for the various levels of uncertainty in consumption.
And that is where XYZ analysis comes into the mix.
While ABC analysis classifies items by value, XYZ analysis categorizes them by uncertainty of demand.
Using ABC analysis together with XYZ gives you a much better overview of which articles in your inventory should get more attention.
It helps avoid shortages and overstocking by providing the basis to accurately determine stock and safety stock levels in case the demand for your SKUs is not always stable.
How to conduct an XYZ analysis
Similarly to the ABC analysis, the XYZ approach divides your stock into three categories.
- X marks items with stable consumption.
- Y marks items with some fluctuation in consumption.
- Z marks items with heavy fluctuation in consumption.
You can categorize your inventory with the XYZ analysis by looking at your items’ historical data and seeing by what margin their weekly or monthly consumption fluctuates.
Pull the data again from your MRP system’s Stock -> Stock movement -> Outward -> Used in manufacturing section, selecting the “Sum per stock item” view and looking at the Cost column for each article.
This time, however, look at the data separately for each month or week.
You can also get a simple visual overview of each item’s fluctuations in stock from your MRP system at Stock -> Items -> Item Reports.
Assigning your items both into the ABC and XYZ categories will give you a classification matrix with 9 categories:
- AX items have high consumption value and stable demand
- AY items have high consumption value and fluctuating demand
- AZ items have high consumption value and greatly fluctuating demand
- BX items have average consumption value and stable demand
- BY items have average consumption value and fluctuating demand
- BZ items have average consumption value and greatly fluctuating demand
- CX items have low volumes and stable demand
- CY items have low volumes and fluctuating demand
- CZ items have low volumes and greatly fluctuating demand
How to use XYZ analysis
You can use the ABC XYZ analysis to better determine the items’ safety stock.
- AX or BX items are stable, so, counter-intuitively, they do not need a lot of buffer for a high service level.
- AY or BY items have noticeable fluctuations so they require more inventory coverage.
- AZ or BZ items have very uncertain demand so they would need a larger amount of safety stock for a high service level. So, it may be reasonable to define a lower service level for these in order to free up cash and reduce standing inventory.
For C class items with low consumption value, you do not need a lot of safety stock by definition.
- Large fluctuations of CX items rarely occur, so they have a very low risk of stock-outs or overstocking.
- CY items would require more safety stock due to fluctuations in demand to prevent stock-outs, but that may not be so important to your core business.
- CZ products can make up a large portion of your inventory and have a high risk of overstocking. For those items, you could have a minimum amount of safety stock available, or none at all.
ABC analysis in warehouse organization
You can also use ABC analysis to physically organize your warehouse. It would be smart to keep goods that are handled often in more accessible places. This could minimize picking time and make your warehouse processes more efficient.
To do this, just replace the SKUs’ consumption value with their total movements during a period.
- Goods that make up 80% of the total movements are class A
- Goods that make up 15% of the total movements are class B
- Goods that make up 5% of the total movements are class C.
Then, organize your inventory so that A-class items are stored closest to dispatch (in the case of finished goods) or the shop floor (in the case of raw materials or parts), B-class items are next in line, and C-class items last. That way goods that are handled most require the least amount of picking time.
Read more about Warehouse Organization: How to Set Up a Smooth-Running Warehouse.
ABC analysis can be used to quickly make your inventory more transparent in terms of the performance of your SKUs.
It helps businesses categorize and prioritize their items based on their consumption value or revenue generated, and allocate resources accordingly.
This could drastically reduce inventory management costs, and prevent both stock-outs and overstocking.
It does have its limitations, though, when dealing with seasonality or other fluctuations in demand.
To mitigate its limitations, use it along with the XYZ method, with which you can also account for fluctuations in demand when determining the SKUs levels of safety stock.
Alternatively, you can use ABC analysis to physically organize your inventory according to the goods’ movement frequency.
You may also like: Inventory Turnover Ratio – Formula and Tips for Improvement