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Effective ABC Analysis in Inventory Management

The annual consumption value is calculated by multiplying the annual usage quantity of each item by its cost per unit. To implement ABC analysis in inventory management, a methodical process should be followed that involves several key steps, each critical to the effectiveness of the approach. The retail and the e-commerce industry usually choose ABC Managementfor customer segmentation. It helps retailers and e-commerce owners to pinpoint their most valuable customers. ABC Analysis is performed using key metrics such as sales revenue, buying potential, and contribution margin.

  • It should be easy for your teams to know which products belong to specific classes immediately.
  • ABC method of inventory control involves a system that controls inventory and is used for materials and throughout the distribution management.
  • The ABC analysis concept is also applied to customers, where the “A” customers generate the most profits and the “C” customers generate the least.
  • Have you heard of SMART goals, but you’ve never used an organized and effective method for setting objectives?
  • Try to make it win-win for both yourself as well as the supplier, and there are chances that you might just out winning the deal.

For example, common classification methods are according to the product’s price or sales frequency. At some point supply chain managers will face https://accounting-services.net/abc-analysis-a-critical-inventory-management-tool/ another problem with ABC analysis. Due to the rise of e-commerce and social media trends may dictate a sudden spike in demand for some items.

Calculation Steps

Every classification should be measured against its own rules set by the initial ABC analysis. This includes a different set of KPIs, performance reviews, and approach to reordering or selling any overstock. Each classification should be assigned its labor level or the number of hours dedicated to working on the particular inventory class. Naturally, the more value or impact the class has on the business, the higher labor levels should be allotted to the classification.

  • Instead of the sales figures, drive your perspective more towards the actionable data.
  • Calculate the aggregate amount for each product by adding up the annual usage value of that product and all the products that come before it in the list.
  • By applying weighed control based on ABC classification, required man-hours and inventory level are drastically reduced.
  • The emphasis is on efficiency and cost-effectiveness, ensuring that these low-value items are managed in a way that does not disproportionately consume resources.

An inventory manager has to give a special status to A-class items and focus on that specific category. But if he finds that the demand for A category items has reduced and that it is no longer generating higher revenue, the products are demoted to a lower category. The way you classify your inventory depends on what kind of business you’re running and your company’s objectives. Your classifications should align with the type of inventory you hold and how your business is run.

What is ABC analysis? Definition and background

Because of the high value of these ‘A’ items, frequent value analysis is required. In addition to that, an organization needs to choose an appropriate order pattern (e.g. ‘just-in-time’) to avoid excess capacity. ‘B’ items are important, but of course less important than ‘A’ items and more important than ‘C’ items. Pareto Principle states that 80% of the sales volume gets generated from the top 20% of the items. It says that in any group, there are significant few and insignificant many.

Why is it Critical to Use ABC Analysis for Inventory Management?

The products are classified according to their importance based on different criteria such as sales ratio, profit margin, and cost of transportation, etc. Inventory optimization is the most crucial reason why ABC inventory analysis is preferred by many businesses. To organize and segregate the products in the inventory as per their revenue and importance. The products are also categorized as per their demands amongst the customer base.

Conducting an ABC Analysis

In the ABC model of inventory control, items categorized under A are goods that register the highest value in terms of annual consumption. It is interesting to note that the top 70 to 80 percent of the yearly consumption value of the company comes from only about 10 to 20 percent of the total inventory items. As demonstrated in the example above, ABC analysis is great for breaking complex processes down to their essentials and presenting them in an easy-to-understand way.

It is most important for companies that seek to bring down their working capital and carrying costs. This done by analysing the inventory that is in excess stock and those that are obsolete by making way for items that are readily sold. This helps avoid keeping the working capital available for use rather than keeping it tied up in unhealthy inventory.

ABC analysis example

Next, it’s essential to classify or organize the inventory in the descending order. Place the maximal-priced product on the top and the minimal-priced item at the bottom. Even during cycle counting – a process where high inventory accuracy can be maintained throughout the year can be done using the ABC method. When a business conducts an ABC Classification, it has two prime objectives. First, to ensure that supply costs are highly competitive and second to boost the cash flow by storing high demanding products in the stock. Similarly, if one perceives the second pyramid representing the percentage of average inventory value, the structure reverses.

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