ABC Inventory | 3 mins read

ABC Inventory Analysis Method - Benefits and Limitations

abc inventory analysis method benefits and limitations
Hanh Truong

By Hanh Truong

In order to effectively manage large volumes of inventory, business owners need to implement practices that will help them better understand their stock and profitability. One such method that companies use to control their stock is the ABC inventory analysis.

This approach directs attention to high-value inventory products, enabling managers to make better decisions, ranging from replenishment to allocating resources.

What is ABC Inventory Analysis?

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The ABC inventory analysis is a method of identifying and prioritizing top-selling and profitable stock items. All inventory products do not have equal value; therefore, businesses will use this approach to categorize all the goods they carry in order of how well they sell.

The Pareto Principle, also known as the 80/20 rule, is often used by businesses to determine their ABC inventory analysis. According to the Pareto Principle, 80% of a company's profit is generated from only 20% of its inventory. By using this approach, businesses can effectively categorize their stock.

Inventory can be put into three different classifications.

  • A Items - These are the most profitable products and they generate 70% of a business's value, however, they usually make up 10% of inventory.
  • B Items - These goods are less profitable, compared to A items. Their value is about 20% and they make up 20% of inventory.
  • C Items - These products are of 10% value but make up a large percentage of inventory with 70%.

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Benefits of ABC Inventory Analysis

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Implementing the ABC inventory analysis requires careful planning and monitoring of inventory. Effectively doing so will provide companies with many advantages that will enhance their profit margin.

Optimize Resource Allocation and Time Management

By classifying and categorizing inventory, business owners can make informed decisions regarding their resource allocation.

For example, since administrators can quickly identify their best selling goods by looking at products in the A rank, they can invest more time into manufacturing those items or allocate more funds into procuring them.

Maintain Optimal Levels of Stock

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The ABC analysis method helps companies gain visibility into what products or services their consumers typically buy and how many. This insight allows managers to determine how much of a certain item they need to have in stock in their store to meet customers' needs, as well as how often they need to restock their warehouse facility.

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Establish Profitable Prices

With the ABC model, companies will know which items are popular among shoppers. Business owners can use this knowledge to their advantage by strategically pricing these items higher than their lesser-demanded products.

This can positively impact a brand's profit margin since most customers will generally be more willing to pay a higher price for a highly-sought-after good.

Effectively Forecast Demand

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Business owners can forecast their consumer base's demands by regularly conducting ABC analysis. They can learn more about their product's life cycle and trends in sales. These insights make it easier for management to predict future demand and prepare their inventory according to the forecasts.

Improve Customer Service

Customers' experiences will be enhanced since businesses can understand and cater to exactly what their buyers need and prefer in a product or service. When shoppers go to a store or browse a company's retail website, they will be satisfied to see that their favorite products are in stock.

Limitations of ABC Inventory Analysis

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When performing the ABC inventory classification, business owners should consider some of the limits that the method has.

New Products

The ABC analysis uses metrics about a product's sales to identify which level it belongs to in the model. However, it will be difficult to classify new products since there will not be historical sales data to examine.

Seasonality

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Seasonality, such as holidays and weather, may also affect the ranking of certain products.

For example, during the winter season, coats and sweaters may be categorized as an A item, while during the summer, they would be demoted to the C rank. Therefore, the classifications will continually evolve and change every given period.

Blindness

The ABC analysis determines a product's importance with how often it is sold and how much revenue they bring into the company. However, there are many other factors that contribute to a product's importance but may not have a large effect on a brand's profitability, and will, therefore, not rank high in the model.

A retail store, for instance, may have specific products in their window display that is responsible for drawing in large amounts of customers. If these items were ranked low on the analysis and business owners do not replenish them, then they will miss out on the potential foot traffic in their stores.

With consideration to the limitations and benefits of the ABC inventory analysis, businesses can develop a model that will help them effectively perform inventory management and meet customer demands.

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