ABC Analysis – Method of Inventory Control and Management

ABC method of inventory control involves a system that controls inventory and is used for materials and throughout the distribution management. It is also known as selective inventory control or SIC.

ABC analysis is a method in which inventory is divided into three categories, i.e. A, B, and C in descending value. The items in the A category have the highest value, B category items are of lower value than A, and C category items have the lowest value.

Inventory control and management are critical for a business. They help to keep their costs under control. The ABC analysis helps the business to control inventory by letting the management focus on the highest value goods (the A-items) and not on the many low-value goods (the C-items).

ABC Method of Inventory Control

It has become an indispensable part of a business and the ABC analysis is widely used for unfinished good, manufactured products, spare parts, components, finished items and assembly items. Under this method, the management divides the items into three categories A, B and C; where A is the most important item and C the least valuable.

ABC inventory analysis is based on the Pareto Principle. The Pareto Principle states that 80% of the sales volume are generated from the top 20% of the items. It means that the top 20% of the items will generate 80% of the revenue for the business. It is also known as the 80/20 rule.

This method is significant to identify the top category of inventory items that generate a high percentage of yearly consumption. It helps the managers to optimize the inventory levels and achieve efficient use of stock management resources.

Need for Prioritizing Inventory

Item A:

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. Hence, it is crucial to prioritize these items.

Item B:

These are items that have a medium consumption value. These amount to about 30 percent of the total inventory in a company which accounts for about 15 to 20 percent of annual consumption value.

Item C:

The items placed in this category have the lowest consumption value and account for less than 5 percent of the annual consumption value that comes from about 50 percent of the total inventory items. 

Note: The annual consumption value is calculated by the formula: (Annual demand) × (item cost per unit)

Policies Governing the ABC Method of Inventory Management

The idea behind using the ABC analysis is to leverage the imbalances of sales. This means that each item must be given the appropriate amount of weight depending on their class:

Item A:

a) These are subjected to strict inventory control and are given highly secured areas in terms of storage

b) These goods have a better forecast for sales

c) These are also the items that require frequent reorders on a daily or a weekly basis

d) They are kept as a priority item and efforts are made to avoid unavailability or stock-out of these items

Item B:

a) These items are not as important as items under section A or as trivial as items categorized under C

b) The important thing to note is that since these items lie in between A and C, they are monitored for potential inclusion towards category A or in a contrary situation towards category C

Item C:

a) These items are manufactured less often and follow the policy of having only one of its item on hand or in some cases they are reordered when a purchase is actually made

b) Since these are low demand goods with a comparatively higher risk of cost in terms of excessive inventory, it is an ideal situation for these items to stock-out after each purchase

c) The questions managers find themselves dealing with when it comes to items in category C is not how many units to keep in stock but rather whether it is even needed to have to these items in store at all.

Uses of ABC Analysis

The ABC analysis is widely used in supply chain management and stock checking and inventory system and is implemented as a cycle counting system.  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. 

When a company is better able to check its stock and maintain control over the high-value goods it helps them to keep track of the value of the assets that are being held at a time. It also brings order to the reordering process and ensures that those items are in stock to meet the demands.

The items that fall under the C category are those that slow-moving and need not be re-ordered with the same frequency as item A or item B. When you put the goods into these three categories, it is helpful for both the wholesalers and the distributors to identify the items that need to be stocked and those that can be replaced.

For Example- ‘H&M’ manufactures 80% of its retail inventory in advance and introduces the remaining 20% based on the most current market trends.

Similarly, ‘Amazon’ does not keep stock of every single item offered on its website. The stocks of only the popular items that are frequently purchased are maintained. If there is an order for an unpopular item, then Amazon would request it from its distributor, who would then ships it to the company.

Advantages of Implementing the ABC Method of Inventory Control

• This method helps businesses to maintain control over the costly items which have large amounts of capital invested in them.
• It provides a method to the madness of keeping track of all the inventory. Not only does it reduce unnecessary staff expenses but more importantly it ensures optimum levels of stock is maintained at all times.
• The ABC method makes sure that the stock turnover ratio is maintained at a comparatively higher level through a systematic control of inventories.
• The storage expenses are cut down considerably with this tool.
• There is provision to have enough C category stocks to be maintained without compromising on the more important items.

Disadvantages of using the ABC Analysis

• For this method to work and render successful results, there must be proper standardization in place for materials in the store.
• It requires a good system of coding of materials already in operation for this analysis to work.
• Since this analysis takes into consideration the monetary value of the items, it ignores other factors that may be more important for your business. Hence, this distinction is vital.

The ABC model works in a manner as to get prime attention to the important items or the critical few and not have unnecessary attention be spent on the not so important items or the trivial many. Each category has a differing management control in place. This prioritization of attention and focus is vital to keep the costs in check and under control in the supply chain system. To get the best results it is important that items that involve a lot of costs are given the due management attention.