The 1-2-3s Of ABC Inventory Analysis: How To Calculate And Implement The Process For Your Business

One of the most frustrating things about inventory management is how it keeps following the Pareto Principle: 80% of your profits probably come from around 20% of your stock. This is a real pain point for inventory managers worldwide—wasting 80% of shelf space, warehouse labor, and logistics to sell stuff that's only 20% of the bottom line. Fortunately, ABC inventory analysis can fix that problem.

In this article, we'll explain how to use ABC analysis, how it works in inventory management, and how to calculate and implement the process.

What Is ABC Inventory Analysis?

ABC analysis is a simple approach to a lot of complex management systems. It works by splitting elements into three categories—A, B, and C—and then assigning them different priorities depending on their importance. Some excellent inventory management software and enterprise resource planning (ERP) tools can do this analysis for you.

However, the system isn't limited to inventory management or inventory control. An ABC analysis and ABC classification can also be helpful for accounts receivable, personnel management, and warehouse operations.

What Is ABC Analysis in Inventory Management?

Classification is at the heart of the ABC method. It works by spreading out all the items in your inventory and ranking them according to their output value. Then, separate the highest-value items from the middle and lowest tiers. Your inventory management software might display the data in any number of ways, or you could build a simple spreadsheet in Excel that looks like this:

This data gives you a snapshot of the 80/20 rule, and a few things pop out.

You can see that the top 20% of items by volume on your shelves are making 80% of your sales output. Meanwhile, the bottom 50% only earns 5% of your sales. It also reveals potential for future revenue growth.

If, for instance, you scaled back your category C inventory and gave all that shelf space over to more category A items, you could see up to a tripling of your return since you'd be moving 2.5 times more high-value inventory.

How to Do an ABC Inventory Analysis Calculation

Getting started with an ABC system to manage your inventory is a three-step process:

Step 1: List your inventory on a spectrum

List all your inventory items in a single place, which can be in a spreadsheet or an enterprise inventory management software, and rank them in descending order according to your preferred metric. Common metrics include:

• Total sales of each item
• Gross margin of each sale
• Purchasing costs
• Holding costs

Step 2: Set boundaries for each category

You have to cut the categories off somewhere, and it's best to set objective criteria for categories A, B, and C beforehand. For instance, if you're tracking sales, you may consider a high-value item to move more than 1,000 units a month. Or you may set a dollar value at $10,000 a month and above as a category A item.

Set a maximum threshold for a category C item, such as 100 units a month or $1,000 in sales. Anything between these values would be a category B item by default.

You're not trapped inside a strict three-item scale. Depending on the needs of your business and what information you're interested in, you could use as many categories as you'd like. The table below shows how you might structure your inventory based on total net profit per category, with much finer divisions than a simple ABC model:

In this table, breaking things down into smaller categories has spread out the 80/20 effect quite a bit, but the data is still useful. In this hypothetical, one category of items, which would usually have been lumped in with category C items, is shown to have low profits and low sales volume, earning it category F status. 

Note that there is still a broad division between the two top tiers, the two middle tiers, and the bottom two, which are each closer to each other than they are to the other item classes.

Step 3: Keep an eye on things and reassess

Nothing in inventory management ever stays the same. As your sales and stock levels evolve, item performance is bound to change. Try to run an ABC inventory analysis at least once a month for every category or data set you're interested in. Do it weekly if you can.

Above all, never hesitate to update or alter the way you treat different items in your stock based on where they sit in your most recent inventory analyses.

Most cloud based inventory management software comes with robust reporting—use it to iterate, improve, and learn.

What Are the Benefits of ABC Inventory Analysis for Ecommerce Businesses?

There's no end to the amazing things you can do with all this information. Here are just 10 ways the ABC inventory analysis system can help your business:

1. Inventory optimization: An ABC analysis optimized for sales volume reveals which items are flying off the shelves and which are sitting under a coat of dust. Look at your figures and start moving things around.
2. Inventory forecasting: The ABC approach helps develop trend lines to see where inventory levels are going over the next few months.
3. Resource allocation: As customer demand shifts from one class of item to another, you'll see it on your ABC sheets. With regular updates, you can reallocate labor and other resources to focus on your class-A items and get the most bang for your buck.
4. Negotiations with suppliers/vendors: The ABC inventory management method shows which items are the most important to keep in stock. Use this information to negotiate a safety stock you must always have while rewarding or incentivizing your vendors.
5.  Life-cycle management: Products have a life cycle, and ABC analysis shines a light on how things are going for each item. Chart the trajectory of an item in your inventory from launch to initial growth, to maturity, and into decline, and know when a drop in sales is organic and permanent.
6.  Prioritize high-value items: Everything in your class-A category is vital to your success, and you should never be without them. Inventory classification using ABC analysis reveals must-have items to reorder in bulk, so you always have extra on hand.
7. Cut the low performers: Every item you keep on hand has carrying charges, which might not be worth the inventory cost for category C stock. Spot these wastes of space early, and cut bait when you can. Fill the empty spot with something else that might have a better profit margin.
8. Simplify your supply chain management: Is it time to merge into a single supply chain for any given item? A rolling ABC analysis gives you month-over-month data to help make these decisions.
9. Improve pricing: If one of your class-C items starts moving up the ranks, it's probably because demand for that item increases. Consider a price increase to make the most out of this fortunate trend.
10. Make customers happy: You should expect the highest customer support demand from sales of your most popular items. Focus the training of your customer service staff on these items.

Learn the ABCs of ABC Inventory Analysis

ABC analysis can be an amazing tool for stock management and long-term sales trends. But there's more to the picture if you're serious about becoming the world's best ecommerce manager, which we assume is why you're here. 

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