ABC classification or analysis is an inventory categorization system used in distribution management to identify and categorize a wide variety of items, such as manufactured products, spare parts, and finished and unfinished goods.
The approach works by placing all inventory items into categories A, B and C, each of which are managed differently. It is based on the Pareto principle, or 80/20 rule, which says that 20 percent of the items will have 80 percent of the value of inventory.
About classes A, B, and C
Following are the characteristics of items belonging to classes A, B and C:
- Class A: Items in this class are extremely important or business-critical. They form the 20 percent of the inventory that accounts for 80 percent of the overall inventory value. They have the highest consumption value either because each individual unit is of high cost or because low-cost units are used in large numbers. Because class A items present a high risk, they are given great care and attention. They are replenished quickly and their production is monitored diligently.
- Class B: These are inter-class items of average importance, inventory value and order frequency. They are produced and reordered regularly in moderate volumes, but not as often as class A items. Although class B items are important enough to be monitored, they don’t need as much control as the other classes. They can be managed through periodic inventory, where updates are made periodically and not as and when needed.
- Class C: This category contains the least important inventory items. C class items can be low-cost units used in large numbers or expensive items that are rarely used. They are usually ordered much less than items of the other classes. They are stocked either in very low quantities or not at all due to high carrying costs. Inventory controls for this class are not strict. They are often automated because there is little chance of significant loss.
Conducting an ABC analysis
Since businesses and the locations that they operate in vary, the items in the A, B, and C classes, their values, and the associated risks also vary accordingly. So, every business should carry out its own analyses with regard to inventory. Following are the steps in conducting an ABC analysis:
- Determine goals and success parameters: ABC analysis can reduce costs or increase liquidity by making the right items available for production or sales.
- Gather data about the current inventory: Accounting departments can provide the necessary data, such as the annual spend per item. This could be the purchase price or the weighted cost, which includes ordering and carrying costs.
- Classify inventory according to order of impact: This refers to ranking all inventory items by cost, from the highest to the lowest.
- Compute accumulated impact of inventory items: This is done by dividing the annual cost of the item by the total inventory annual spend and adding the result to the cumulative total of the percentage spent.
- Divide inventory into classes: This works best when businesses adopt a holistic approach and find areas where contracts, vendors, sourcing methodology, or procurement can be improved. It helps make a significant increase in savings and availability of inventory items.
- Analyze classes and make appropriate decisions: This step consists of periodic tracking to ensure that the classification is correct.
Benefits of ABC analysis
ABC analysis is widely used to improve inventory systems and supply chains. It helps maintain a clear idea of the asset volume and value being held at any time, and assists with ordering items at the optimal time.
It provides businesses with better control over their inventory, which improves availability and reduces losses and costs. Customer demands are met without worry or loss.
ABC analysis is a valuable tool that enables businesses to streamline their inventory systems to continually improve their supply chains.