Inventory management is a major issue for any business that sells physical products, for they must ensure a balance between inventory level and associated costs. Restocking must be regular and adapted to demand to avoid stockouts, as well as overstocking that can increase company costs.
The ABC method, used by many companies, highlights the most important products that require more rigorous management. In this article, we will discuss what the ABC method entails and how it can help optimize your business inventory management. We also offer a free tool to apply the ABC method to your products.
What is the ABC method?
The "ABC method", also known as ABC analysis, is a classification method that categorizes products based on their importance or value. It helps in managing inventory by prioritizing items that require more attention and resources. Products are classified into three categories:
- Category A includes 20% of products that represent 80% of inventory value or sales revenue. These products must be closely monitored because they are the most expensive to stock or the best-selling, therefore they have a significant impact on the company's cash flow.
- Category B includes 30% of products that represent 15% of inventory value or sales revenue. These products must be regularly monitored but not as closely as category A products.
- Category C includes 50% of products that represent 5% of inventory value or sales revenue. These are the least sold or low-value products. These products do not need to be closely monitored as they have a limited impact on the company's cash flow.
The ABC method thus allows for more time and energy to be devoted to the most important products and reduces costs related to less important products.
Note: This method is based on the Pareto Principle, also known as the 80/20 Rule, which states that 20% of products represent 80% of inventory value.
How to implement the ABC method
Depending on the goal you set, you can use one of these calculation methods.
ABC Analysis based on stock value
To categorize your products according to the value of your stock, here are the steps to follow:
- Collect data for each item: unit costs and quantities in stock.
- Calculate the total value of each reference by multiplying its unit cost by its quantity in stock.
- Sort the total value column in descending order.
- Calculate the cumulative percentage of the total value for each reference, and add it to the cumulative percentage of the previous items.
- Classify items into three categories: A, B, and C. Category A items generally represent about 80% of the total stock value, category B items represent about 15% of the total stock value, and category C items represent the remaining 5%.
ABC Analysis based on sales
To categorize your products according to sales, here are the steps to follow:
- Collect data for each item: unit retail price and quantities sold in a given period, such as the last 12 months.
- Calculate the total revenue for each item by multiplying its unit retail price by the quantity sold.
- Sort the total revenue column in descending order.
- Calculate the cumulative percentage of the total revenue for each reference in descending order.
- Classify the products into three categories: A, B, and C. Category A products generally represent about 80% of the total sales value, category B products represent about 15% of the total sales value, and category C products represent the remaining 5%.
ABC Analysis in Excel
For these two calculation methods, Erplain has created a tool available now:
It should also be noted that the cumulative percentages may vary. Below 80%, category A is assigned by default, between 80% and 95%, category B is assigned, and above 95%, category C is assigned.
Important: Remember to regularly review your ABC classification to account for market fluctuations, changes in customer behavior, and industry trends. Adjust your actions accordingly.
ABC Analysis example:
Let's take the example of a company that wants to use the ABC method to classify its products. It wants to categorize its products based on available stocks and sales made.
Here are the available data:
ABC Analysis based on available stocks
The company will have to:
- Calculate the total inventory value by multiplying the quantity in stock by the unit cost.
- Sort the items based on the total inventory value in descending order.
- Calculate the cumulative value percentage line by line to identify items in categories A, B, and C.
According to the table, the company will need to control and optimize its inventory management for "Item #2" by implementing the actions mentioned here.
Here is the ABC analysis obtained by taking into account the total number of items:
ABC Analysis based on sales:
The company will have to:
- Calculate the revenue for each item by multiplying its retail price by the number of quantities sold.
- Sort the items based on their revenue in descending order.
- Calculate the cumulative percentage of revenue for each item to determine category A (items that represent 80% of revenue), category B (the following items), and category C (the remaining items).
According to the table, once again, the company will need to focus its efforts on "Item #2".
Here is the ABC analysis obtained by taking into account the total number of sales:
What are the benefits of the ABC method?
The ABC method allows companies that sell physical products to optimize their management by:
- Determining the relative value of their products and better understanding where they should concentrate their efforts in stock management and sales, thus reducing costs associated with less important products.
- Allocating their resources more effectively.
- Making informed decisions about their purchases, storage, and stock rotation.
- Identifying products that require additional marketing efforts or expenses.
- Offering discounts, promotions, or bundles for category C products or integrating them with category A or B products to sell larger quantities.
ABC analysis in inventory management
With the ABC method, stock management can be optimized in the following ways:
- Restocking: It is essential to establish a reorder point and a safety stock for category A products to avoid stockouts and reduce storage costs. Erplain integrates these features.
- Stock valuation: Methods such as LIFO, FIFO, or MAC can be used to better profit from your stocks based on associated costs.
- Storage space organization: Items from category A should be easily accessible and placed near the order preparation/fulfillment area, while those in category C can be located in a more distant area.
- Stocktaking rates: Category A products will require more frequent stocktaking.
- Storage space size: Directly linked to storage costs, the allocated space should be larger for category A stocks and limited for category C stocks.
It should be noted that the ABC method (Activity Based Costing) can be used not only for stock and sales management, as explained in this article, but also for customer and supplier management. By examining the contribution of each customer or supplier to the company's revenue, the company can optimize its sales and supplying strategy, paying particular attention to category A customers and suppliers.
Want to learn more about the ABC method and inventory management?
Go further:
How to calculate your reorder point and EOQ to increase profitability
Inventory management: issues, optimization, and methods
