ABC analysis, also known as the Pareto method, is one of the most popular techniques for managing inventory, production, and logistics. It involves dividing an assortment of products into three groups according to their value to the company. The ABC method allows us to manage resources better and focus on the items that generate the most benefit or require the most attention. It will enable companies to optimize their operations, improve efficiency, and better allocate resources.
ABC analysis - what does it mean?
The name “ABC” refers to three main categories for allocating goods or resources:
- A - essential items that account for the most significant portion of value, but their number is usually the smallest. Usually, about 20% of the inventory generates 70-80% of the value.
- B - the intermediate category, i.e., products or resources with moderate value for the company. This is about 30% of goods, which generate about 15-25% of value.
- C - the least important products, which generate the least amount of value, but their number is the highest. About 50% of inventory creates only 5-10% of value.
ABC analysis, also called Pareto analysis, is based on the Pareto principle, in which 20% of causes are responsible for 80% of effects. Applying this method to companies allows them to focus on the most critical resources that significantly impact financial performance.
What is the ABC method based on?
The ABC method involves analyzing an assortment of products based on their value. The principle is simple – products or resources are classified according to their value to the company’s total revenue or cost. The process consists of several steps:
- Identifying products or resources: The first step is determining the complete list of goods, resources, or services to analyze.
- Calculating the value of each product: each product should be evaluated based on its contribution to the value of sales, purchase costs, revenue generated, or another critical indicator.
- Sorting the products: after calculating the value for each item, the products should be sorted from highest to lowest value.
- Categorization: The products are then classified according to the 80/20 rule. The most important 20% of the elements (category A) account for most of the value, the next 30% (category B) are intermediate elements, and the remaining 50% (category C) account for the smallest part of the value.
ABC classification - how do you prepare the breakdown?
Preparing ABC classification in practice requires following several key steps:
- Gather data: Collect all necessary data on inventory or products. This could include sales, purchase costs, margins, or the frequency of use of goods.
- Calculate each item's contribution to the total value. Each item should be evaluated in terms of its value to the company, such as revenue or production costs.
- Divide the elements into groups: divide the assortment according to the Pareto principle - 20% of the resources generate 80% of the value (group A), 30% of the resources generate 15-25% of the value (group B), and 50% of the resources are responsible for only 5-10% of the value (group C).
- Apply the classification in practice: Products from group A should receive the most attention—it is worth using more advanced management strategies for them, while items from group C can be managed more simply due to their lower importance.
ABC method - examples
Example 1: Inventory management
Imagine a company that sells electronics. An ABC analysis shows that A products (e.g., laptops and smartphones) account for 20% of the product mix but generate 80% of revenue. B products (e.g., accessories) are 30% of the assortment, generating 15-20% of revenue, and C products (e.g., cables, cases) are 50% of the assortment, generating only 5-10% of income. In this case, the company can focus its activities on group A to better manage resources and optimize sales.
Example 2: Manufacturing
In the case of a manufacturing company, ABC analysis can look at the raw materials used in the production process. A-grade raw materials are the most essential and most expensive or frequently used items. B-grade raw materials are of average value, and C-grade raw materials are rarely used and account for a small percentage of total costs.
ABC analysis - when is it worth conducting?
ABC analysis is helpful in many cases, and its application can help a company at various stages of its operations:
- Inventory management: A company can use ABC analysis to better manage its inventory. Instead of paying the same attention to every product, it can focus on the essential items that bring the most benefit.
- Production optimization: For manufacturing companies, ABC analysis can help identify the most essential raw materials critical to the production process.
- Resource management: The analysis can also help manage time, costs, and even employees - identifying the areas that generate the most value for the company.
- Purchasing planning: In logistics and sales, the ABC method allows for better purchase planning so the company can avoid overstocking low-value goods.
In summary, ABC analysis is a versatile tool that can be used in various aspects of a business. It helps identify critical resources, better manage them, and focus attention on elements that have the most significant impact on company performance. In practice, it is one method that leads to more effective management and operations optimization.
