What is it?
ABC analysis is an approach for classifying inventory items based on the items’ consumption values. Consumption value is the total value of an item consumed over a specified time period, for example a year. The approach is based on the Pareto principle to help manage what matters and is applied in this context:
A items are goods where annual consumption value is the highest. Applying the Pareto principle (also referred to as the 80/20 rule where 80 percent of the output is determined by 20 percent of the input), they comprise a relatively small number of items but have a relatively high consumption value. So it’s logical that analysis and control of this class is relatively intense, since there is the greatest potential to reduce costs or losses.
B items are interclass items. Their consumption values are lower than A items but higher than C items. A key point of having this interclass group is to watch items close to A item and C item classes that would alter their stock management policies if they drift closer to class A or class C. Stock management is itself a cost. So there needs to be a balance between controls to protect the asset class and the value at risk of loss, or the cost of analysis and the potential value returned by reducing class costs. So, the scope of this class and the inventory management policies are determined by the estimated cost-benefit of class cost reduction, and loss control systems and processes.
C items have the lowest consumption value. This class has a relatively high proportion of the total number of lines but with relatively low consumption values. Logically, it’s not usually cost-effective to deploy tight inventory controls, as the value at risk of significant loss is relatively low and the cost of analysis would typically yield relatively low returns.
Since businesses are not all the same, the thresholds that define the upper and lower limits of each class are not definable. Nor will they necessarily be fixed over time or across all locations. A business may have different risk appetites between different locations. For example, a location in a high-crime area may have a higher proportion of A items or, where a facility is less secure, more items may be classed as A. The management accountant should carry out risk and stock management cost-benefit analyses by location to deliver the optimal overall cost-benefit balance and to set the ABC ranges.
To illustrate the concept, a business may set the following class limits:
What benefits does the approach provide?
Better control over high-value inventory improves availability, and reduces losses and costs.
More efficient use of stock management resources. For example, during stock count more resources are dedicated to A class than B or C class holdings, or fewer counts are made of B or C class holdings – which saves time and money.
Relatively low value of B or C class holdings can allow a business to hold bigger buffer stocks to reduce stock outs.
Fewer stock outs resulting in improved production efficiency.
Fewer stock outs and improved production efficiency resulting in more reliable cycle time and, therefore, improved customer satisfaction.
Implementing ABC inventory management? Questions to consider
Is there reliable and accessible cost and demand information by item?
Will your inventory management systems and processes facilitate efficient and effective implementation and operation of the ABC approach?
Have the costs and benefits of implementing and operating ABC been quantified and is the business case compelling?
Has the impact of the change to ABC on capability been assessed and planned for?