Advantages and Disadvantages of ABC Analysis

What does ABC analysis mean?

In inventory management, the term "ABC analysis" refers to categorizing your goods according to their value to your company. The things are divided into classes A, B, and C, and the items are classified based on risk, demand, and cost. You can utilize ABC analysis to identify the inventory items that are most important and valuable for your company. The most significant SKUs are class A products, while the least considerable SKUs are class C items. Some companies divide the classification further by starting with class A products and moving up to class F.

Why should a company think about applying the ABC analysis?

ABC analysis allows you to understand capital costs better and maintain control over them. By doing this, you can reduce your inventory no longer needed and increase the rate at which your company's inventory is turned over. Additionally, it makes it simpler for inventory managers because they know which inventory products should take priority and which are crucial for the company's success. Inventory managers note that they have the right purchase orders because the class A items are linked to producing the highest revenue.

How is the ABC inventory analyzed?

Multiplying an item's annual sales by cost will get an ABC inventory analysis. You may focus your people and financial resources where they will be most effective by knowing which products are high priority & low profit.

Use the formula given to analyze an ABC inventory

(Estimated annual units sold) x (Item cost) = (Annual usage value per product)

You can use Microsoft Excel to carry out a basic ABC inventory analysis. Indicate the value of each good or service's product consumption in decreasing order for each item. Determine the sum of each item in the total amount. Assign each item a group name after determining the values for the A, B, and C categories. The management then pays particular attention to the items with the highest value.

Inventory control, 80/20 Rule, and ABC Analysis

The Pareto Principle, often known as the 80/20 rule, states that a relatively small proportion of inventory goods account for the most utilization value.

The 20% of inventory goods classified as "A" have the highest usage value, accounting for about 80% of the total usage value of the company.

Items categorized as "B" comprise around 30% of the inventory and account for about 10% of the utilization value.

The remaining inventory comprises items classified as "C," making only 10% of the utilization value.

What is the ABC analysis process?

The following are the steps in completing an ABC analysis.

Step 1: Decide on your objective.

To start, decide what your goal is. Do you wish to use the analysis to improve your company's cash flow? Or do you want to cut your buying costs? Make sure you carefully consider what you hope to accomplish with the analysis.

Step 2: Gather the necessary data.

You must get the right data to accurately classify the goods and base decisions on that. You must know each item's annual cost, and the carrying cost and gross profit margin should then be determined.

Step 3: Classify using the formula.

The annual utilization value for each product should be determined using the ABC analysis formula previously indicated. After completing the calculations, you should rank the items based on cost, and the most expensive products should be at the top.

Step 4: Determine the effect on sales

Divide the annual cost of each inventory item by the total cost of all items to get the impact on sales. Then divide this result by 100 to obtain a percentage. This is useful for comparing the different things on the list.

Step 5: Arrange products into classes

Defining the classes initially is the best course of action. After that, you should concentrate on the negotiation phase and then the consolidation procedure. These may reduce costs, promote savings, and guarantee that class-A objects are constantly accessible.

Step 6: Perform a thorough analysis

After the cost management measures have been decided, this step entails analyzing the classes. The process must include frequent reviews since they show whether the choices were good or needed to be revised.

The Simplified ABC Analysis Work for Inventory Managers

Inventory managers constantly look for ways to increase efficiency, raise quality, or lower prices. They might employ the ABC methodology, sometimes known as the "always better control" method, in light of that goal. They can utilize the study to devote more time and resources to Class A inventory while reducing their attention to B & C class products. Since Class A items produce the most money, inventory managers might first utilize ABC analysis to review the purchase orders for these products.

Why would someone use ABC analysis?

Businesses can manage their inventory based on important metrics by using ABC analysis. A company must comprehend consumer demand to ascertain whether or not its customers would purchase a specific product. Businesses that choose ABC analysis have the opportunity to assess demand & manage their inventory based on this information.

Stock optimization is another reason why organizations utilize ABC analysis. To satisfy cleansing the information, business owners can strategically establish prices for their goods or service of client needs; a business should classify its items based on demand, importance, & profit to generate a sizable amount of sales and a larger profit. Assists in identifying and reducing the number of products with low-profit margins or those customers dislike. Entrepreneurs who use the strategy get a smoother supply chain, pay less for extra stock, and effectively use their resources.

Now you know how ABC analysis is used, let's move on to the advantages and disadvantages of this approach.

Advantages of using ABC analysis

Applying ABC analysis to inventory management can have a wide range of advantages, including:

1. Better inventory optimization: The study reveals which products are in high demand. Once those products are fully stocked, a business can use its limited warehouse space to keep Class B or C items at reduced stock levels.
2. Improved Inventory Forecasting: By keeping tabs on and compiling information on goods with high customer demand, accurate sales forecasting can be improved. Managers may use this data to decide on inventory levels & prices to increase overall company revenue.
3. Better Pricing: A growth in sales for a certain product may indicate that demand is increasing, allowing for a price increase while still retaining profitability.
4. Informed Supplier Negotiations: It makes sense to negotiate with suppliers for better terms on Class A items since they make up 70% to 80% of a company's revenue. If the vendor doesn't agree to cut rates, try negotiating after-purchase services, down payment discounts, free delivery, or other cost savings.
5. Strategic Utilization Of resources: ABC analysis can be used to monitor resource allocation over time to ensure that Class A items are produced by consumer demand.
6. Improved Customer Service: Service levels are influenced by various variables, including the quantity sold, the price of the goods, and profit margins. A better understanding of a product's life cycle stages the stages of a product's life cycle is necessary for accurate demand forecasting and inventory management (launch, growth, maturity, or decline). Offer greater service standards for the items you've determined to be the most beneficial.
7. Control over pricey items: A company's Class A inventory directly affects its success. Prioritize monitoring demand and maintaining healthy stock levels to guarantee that there is always a sufficient supply of the necessary products accessible.
8. Sensible Stock Turnover Rate: You can maintain a sensible stock turnover rate by meticulously managing inventories and gathering data.
9. Reduced Storage Expenses: By maintaining the proper stock level depending on the A, B, or C classes, you can lower the carrying costs associated with maintaining surplus inventory.
10. Simplified Supply Chain Management: To reduce carrying costs and simplify processes, analyze ABC inventory data to determine whether it's time to merge suppliers or go with a single one.

Disadvantages of ABC Analysis

Despite its benefits for maintaining and managing inventories, ABC analysis is a more than one-size-fits-all approach. The application of an ABC study is impacted by the distinctive consumer demand patterns, classifications, systems, & other issues each organization encounters. One drawback of ABC analysis is that it focuses on the monetary value of inventory, and another is that it takes a lot of effort and discipline to apply. Other drawbacks include the following:

1. Parameter Instability: Due to the results of the ABC analysis, managers commonly assign up to 50% of the items to a different category every quarter or year. The need to review could save time and decrease client satisfaction because businesses typically only realize the changes exist once there is a demand issue.
2. Limited Pattern Consideration: The conventional ABC method does not account for seasonality or the introduction of new products. Due to its generally static perspective of demand, ABC analysis will need inventory inefficiencies when the demand is fluctuating or uncertain. For instance, a new product's poor sales volume could be explained by needing a consumer base.
3. Low Knowledge Extraction: The information from the ABC class will give you only some of the facts or specifics you need to make intelligent, strategic management decisions.
4. High Resource Consumption: One unfavourable outcome of ABC analysis is the practice known as "bikeshedding," which involves giving excessive weight to unimportant matters. Due to the ease of understanding of ABC analysis, staff members may contribute their thoughts or look for their variations, turning it into a resource-intensive procedure rather than a time-saving tool.
5. Value Blindness: While ABC analysis based a product's importance on income or usage volume, some products may resent this paradigm. For instance, even though a retail display item rarely sells, its novelty may generate many customers (who will buy other goods). In the aerospace sector, a specific plane component could not be used frequently and have a low market value, but it might play an essential safety role.
6. System differences: ABC inventory analysis conflicts with traditional costing methods and does not follow "generally accepted accounting principles" (GAAP). Running several costing systems will result in higher labour costs and decreased efficiency.
7. Issues with Undersupply or Oversupply: One drawback of ABC analysis is that it considers dollar values rather than the volume that moves through inventory, which increases the possibility of running out of Class B or C items. The inverse can also take place. If you keep placing orders without reviewing them regularly, you can have too many low-class things gathered in your inventory.
8. Loss Risk: B & C products aren't always useless just because they're less valuable than Class A products. The fact that excess stocks are continually at risk of being damaged or deteriorating is one of the weaknesses of the ABC analysis. As a result, routinely uncounted or unmonitored inventory could be lost.
9. Mandatory Standardization: The ABC approach can only be effective if every component is subject to compulsory standardization of materials, which includes how each component is labelled, stored, uniformly rated, and monitored.
10. Arbitrary Categorization: In the absence of predetermined limits or established criteria for each group, classifying items relies on the manager's expert judgment. As a result, this method may be quite subjective.
11. Business Restrictions: Businesses with an equal yearly consumption value of inventory items by type cannot benefit from ABC analysis. For instance, according to the Pareto Principle, a business that sells identical models of items like candy, nails, or socks might need help organizing its stock.
12. High Resource Consumption: Using ABC categorization to manage inventory may need companies with many inventory items to engage more staff or purchase specialized equipment.

ABC Analysis's Benefits and Drawbacks in Brief:

Benefits:

1. It is appropriate for large manufacturing organizations.
2. It ensures better inventory control by reducing waste and incorrect material utilization.
3. It raises the ratio of stock turnover.
4. Storing resources saves money and time.
5. The decrease in time and costs and the efficient control and use of resources contribute to the business's increased profitability.

Drawbacks:

1. It is not appropriate for small businesses because it uses many resources.
2. It is more complicated than other inventory control methods.
3. It lacks dynamism & adaptability.
4. It disregards GAAP.