The ABC Analysis

Introduction

ABC analysis is a method of classifying items, according to their relative importance. This analysis aims to define groups of items which have varying levels of significance and must therefore be processed or controlled differently to each other.

This analysis is based on the Pareto principle (also known as the 80–20 rule). It states that, for many events, roughly 80% of the effects come from 20% of the causes.
It is frequently used in inventory management where it is used to classify stock items into groups based on the total annual expenditure for each item. Organizations can concentrate more detailed attention on the high value/important items.

ABC analysis categories

ABC analysis requires that items (activities, customers, documents, events, inventory items or sales territories, etc.) are categorized into three groups based on their presumed significance. Three categories (A, B, and C) can be defined as follows:
- A-items are especially important
- B-items are of average importance
- C-items are minimally important

There are no fixed threshold for each class, different proportion can be applied based on objective and criteria. According to the principle the A-items will typically account for a large proportion of the overall value but a small percentage of number of items. The following table shows general rules for ABC analysis

ABC for Inventory Items

In a production system the number of items can be very high. However, not all items have the same cost and are used in the same quantities. The inventory items should be items that accounts for the greatest value. In order to determine which items there are two variables must considered: item demand and unit cost for each item. To determine the usage value of an items, multiply the quantity over a given period by unit cost.

Inventory items can be classified into these categories:
⦁ A-items are goods which usage value is highest
⦁ B-items are the interclass items, with a medium usage value
⦁ C-items are items with the lowest usage value

Therefore, those items that are the most demanded and most costly are the most important inventory items. With only two data you can rank all your inventory by importance; this classification is the first step towards controlling independent demand inventories.

The following procedure is one way of implementing an ABC analysis:

1) Find out the unit cost and the quantity of each item over a given period
2) Calculation of usage value of each item
3) List out all the items based on their usage value in decreasing order
4) Calculation of the accumulated value
5) Classify items into A,B and C items groups

The percentage of the total items included in any class is quite arbitrary, but the common values are given into previous table. A typical curve, result of the ABC analysis, is given below

Inventory management policies

Policies based on ABC analysis leverage the sales imbalance outlined by the Pareto principle. Each item should receive a treatment corresponding to its class:

⦁ A-items should have tight inventory control, more secured storage areas and better sales forecasts. Reorders should be frequent, with weekly or even daily reorder; avoiding stock-outs on A-items is a priority.

⦁ B-items are an intermediate status between A and C. An important aspect of class B is the monitoring of potential evolution toward class A or, in the contrary, toward the class C.

⦁ C-items should be reordered less frequently. A typically inventory policy for C-items consist of having only 1 unit on hand, and of reordering only when an actual purchase is made. This approach leads to stock-out situation after each purchase which can be an acceptable situation, as the C-items present both low demand and higher risk of excessive inventory costs.

Download here an ABC Analisys Exercise >