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:
- Sales revenue generated by each product
- Contribution made by each product
- Level of investment or simply cost incurred on each product
- NRV of each product
- 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:
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|
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.