ABC inventory classification (ABC method, ABC analisys) – The method of ABC classification analysis is one of the most adopted techniques in the industrial units. Company inventories are classified into different categories based on the value and frequency of replenishment in the given period.
The most important element in this classification is a chosen criterion (you can focus just on one criteria) e.g. volume of material release, the value of sold products. „The first step in the ABC analysis is to create a ranked list of items by cost of goods sold. The top 20% of the items are labeled A-items. The next 30% of the items in the list are labeled B-items and the remaining % are labeled C-items. Of course, these percentages can vary depending upon the needs of the firm”(Chad W. Autry and others, 2013, s.103).
The ABC analysis is based on the principle of determining the Lorenz curve, „where the x-axis is the percentage of items ant the y-axis is the percentage of total annual usage” (Chad W. Autry and others, 2013, s.103). During creating ABC analysis it is necessary to order inventory positions from the biggest to the lowest values according to the adopted criterion.
Inventory groups in the ABC classification
ABC Inventory Classification divides inventories for three groups:
- Group A
„Group ‘A ‘ items, consist of only a small percentage of the Total items handled but Has a combined value that constitutes a major large portion of a Total Stock holding of the concern” (D. Chandra Bose 2006, s.33). They „require tight control and the most accurate record-keeping. These are typically to high-value items, and though few in number, they can make up 70 to 80 % of the total inventory value” (Lea R. Dopson, David K. Hayes, 2010, s.192).
- Group B
As D. Chadra Bose says, items from group B are less important compared to items from group A (D. Chandra Bose2006, s.33), which „are those that make up 10 to 15 % of the inventory value and require only routine control and record-keeping” (Lea R. Dopson, David K. Hayes, 2011, s.192).
- Group C
„In contrast, C items are not as important from an investments point of view and therefore should be ordered and counted less frequently” (Chad W. Autry and others, 2013, s.103). These „items make up only 5 to 10% of the inventory value. These items require the simplest of inventory control systems. (Lea R. Dopson, David K. Hayes, 2010, s.192).
Phase the ABC inventory classification
The five steps in ABC are (Jae K. Shim, Joel G. Siegel, Allison I. Shim, 2012, s.409):
- Segregate inventory into components.
- Compute annual dolar usage by inventory type.
- Rank inventory according to dolar usage ranging from high to low (e.g., As in top 30 percent. Bs in next 50 percent, and Cs in last 20 percent).
- Tag inventory with the appropriate classification so proper attention can be given to it.
- Record classifications in the inventory records.”
Pros and cons of ABC inventory analysis
Strengths
- Lower risk of stockouts for high-value products
- Stock management efficiency
Weaknesses
- Limited flexibility for nonstandard items
- Potential for overcomplication
When you use ABC analysis, you can easily prioritize management tasks for the items that have the biggest impact on your business. This ensures that your class A items get the most attention, so you’re less likely to run out of safety stock on your highest-value products.
ABC classification also helps make your stock management process more efficient, since your inventory planner knows exactly which items to focus on to minimize your costs and maximize your profit.
ABC inventory can be somewhat limited, however. For starters, classifying items by their usage value means new items (with no sales data to draw from) have zero usage value.
It also doesn’t account for items that would normally be class B or class C items but need to be temporarily treated as class A items. So let’s say a manufacturing issue forces you to immediately reorder all your stock on a C-level item. You may need to temporarily treat that item as an A-level item, but your system would de-prioritize tasks for that item because it’s technically a C-level product.
Now, you can create a list of products that are exceptions to your ABC classification. But that means every time you reclassify your items (which we recommend doing regularly), you need to compare your classification to your list of exceptions and adjust. This can get inflated and overcomplicated very quickly, especially if multiple people within your organization have a say over how products get prioritized.
How to apply ABC inventory classification
Analyze your current system
The first thing you need to do if you want to implement ABC analysis is analyze your current system to make sure it can handle operating with the ABC approach. If your system doesn’t currently allow you to prioritize some items over others, you may have to revamp your entire inventory management system—which can be expensive, time-consuming, and altogether frustrating.
To start using the ABC code, you’ll also need to ensure that you have accurate records on inventory cost and customer demand. Both cost and demand are important elements to determining each item’s usage value—without these details you won’t know which items to sort into category A and which to sort into category C.
Calculate values
It’s time to start figuring out how each of your products contribute to your business. Here’s how:
1. Determine the time period for your analysis. While many businesses opt to use annual consumption value (which analyzes the amount and cost of products sold within the past year), you could choose to look at sales for just the past month or quarter—the choice is yours.
2. Find the usage value of each item by multiplying the number of units sold by the total cost per item.
Usage value = units sold x cost per item
3. Calculate your total inventory value* by adding all the individual usage values for your products.
Total inventory value = product 1 usage value + product 2 usage value + etc.
4. Sort products (within your Excel spreadsheet or whatever tool you’re using) from highest usage value to lowest.
5. Calculate each item’s cumulative value by dividing the product’s inventory value by the total inventory value, then multiplying by 100. This should give you the percentage of your total inventory value that can be attributed to each item.
Cumulative value = (product inventory value / total inventory value) x 100
Keep in mind that while most inventory planners can calculate these values manually, any inventory management software that supports ABC analysis should be able to calculate these values for you automatically.
References
- Autry Ch. W., Bell J. E., Goldsby T. J., Hill A. V. (2013), Managing the Global Supply Chain (Collection), Pearson Education, Inc., Publishing as FTPress Delivers, Upper Sadle River, New Jersey.
- Bose D. Ch. (2006), Inventory management,Prentice-Hall of India Private Limited, New Delhi.
- Dopson L. R., Hayes D. K. (2011), Food and Beverage cost control, John Wiley & Sons, Inc., New Jersey.
- Siegel J. G., Shim A. I., Shim J. K. (2012),CFO Fundamentals: Your Quick Guide to Internal Controls, John Wiley & Sons, Inc., New Jersey.