What is ABC Analysis?

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ABC analysis is one of the known inventory classification methods available in which inventory is categorized in three classes A, B and C where A being most important, B being important and C being less important. ABC analysis is also known as Pareto Analysis, Pareto rule or 80/20 rule.

ABC analysis must not be confused with Activity Based Costing which is also termed as ABC.

In ABC Inventory analysis, products are categorized on the basis of their importance to the entity rather than their quantity in the warehouse. Importance on the other hand can be judged in difference ways like:

  1. Sales revenue generated by each product
  2. Contribution made by each product
  3. Level of investment or simply cost incurred on each product
  4. NRV of each product
  5. Turnover period of each product

Its up to the management to decide what basis to use for classification but mostly sales revenue or cost basis are used for ABC. One thing to remember however is that inventory is not just stock as it can be anything like creditors, debtors, investments etc. So the use of word inventory is little generic in this analysis and not specifically meant to be units produced or purchased. We can classify debtors on the basis of debt. Similarly we can classify creditors on the basis of amount owed to them.

The main reason why importance based classification so important is that organizations must concentrate more on those items that are more valuable and prove more worthy to entity. For example if entity’s offering many different products to customers is analysed on sales revenue generated by each product, it is observed that the products generating majority of revenues are in minority like, 10% of total units sold generate 90% of revenue.

Understanding what is important and then reinforcing efforts in that direction will benefit entity even more therefore, ABC analysis helps management in identifying such elements.

Have a look at the following data where we know about 49 different products an entity sells with their sales value:

Serial Number Amount
1 20,000
2 17000
3 14450
4 12283
5 10441
6 8875
7 7544
8 6412
9 5450
10 4633
11 3938
12 3347
13 2845
14 2418
15 2055
16 1747
17 1485
18 1262
19 1073
20 912
21 775
22 659
23 560
24 476
25 405
26 344
27 292
28 248
29 211
30 179
31 152
32 129
33 110
34 94
35 80
36 68
37 58
38 49
39 42
40 36
41 31
42 26
43 22
44 19
45 16
46 14
47 12
48 10
49 9

Ordinarily all 49 are given equal care which in fact is not necessary and might be detrimental to entity. If we find the total of sales from all 49 products we find it to be 133,296

To conduct ABC analysis we need two more columns i.e. one in which cumulative sales are calculated and second that gives the percentage total:

Serial Number Amount Cumulative Sales Percentage
1 20,000 20,000 15.00%
2 17000 37,000 27.76%
3 14450 51,450 38.60%
4 12283 63,733 47.81%
5 10441 74,174 55.65%
6 8875 83,049 62.30%
7 7544 90,593 67.96%
8 6412 97,005 72.77%
9 5450 102,455 76.86%
10 4633 107,088 80.34%
11 3938 111,026 83.29%
12 3347 114,373 85.80%
13 2845 117,218 87.94%
14 2418 119,636 89.75%
15 2055 121,691 91.29%
16 1747 123,438 92.60%
17 1485 124,923 93.72%
18 1262 126,185 94.67%
19 1073 127,258 95.47%
20 912 128,170 96.15%
21 775 128,945 96.74%
22 659 129,604 97.23%
23 560 130,164 97.65%
24 476 130,640 98.01%
25 405 131,045 98.31%
26 344 131,389 98.57%
27 292 131,681 98.79%
28 248 131,929 98.97%
29 211 132,140 99.13%
30 179 132,319 99.27%
31 152 132,471 99.38%
32 129 132,600 99.48%
33 110 132,710 99.56%
34 94 132,804 99.63%
35 80 132,884 99.69%
36 68 132,952 99.74%
37 58 133,010 99.79%
38 49 133,059 99.82%
39 42 133,101 99.85%
40 36 133,137 99.88%
41 31 133,168 99.90%
42 26 133,194 99.92%
43 22 133,216 99.94%
44 19 133,235 99.95%
45 16 133,251 99.97%
46 14 133,265 99.98%
47 12 133,277 99.99%
48 10 133,287 99.99%
49 9 133,296 100.00%

If we investigate on ABC basis using the revenue contributed by each product we find that out of 49 only 7 products are making up 70% of entity’s revenue. In other words roughly 14% of the total products are generating 70% of revenue and thus considered most important and requires close attention. These 6 products will be classified as “A”.

On the same basis we can find the products that belong to category B and C.

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