ABC Analysis - Supply Chain In 3 Minutes

ABC analysis is one of the simplest inventory categorization methods which divides items and categories based on their perceived importance. The method has its roots in the Pareto principle, a technique which first originated in the 19th century. Vilfredo Pareto observed that around 80 percent of the total wealth in England was actually belonging to only 20 percent of the population. Around half a century later, it was realized that this rule could be applied to a wide range of things other than just basic economics. As a result, the 80/20 rule was born.

So, why is this rule interesting for supply chain management? Well, let's start off by using the example of a supermarket. Here, it can be shown that 80 percent of the overall consumption actually only comes from 20 percent of the items within a store. When you think about this, it is something which you can certainly see as true. The battery shelf is much smaller and replenished less often than the mountain of Coke we seem to get on a daily basis. Now, if you're a store manager, this fact is pretty important because it means that just 20 percent of your total offering is actually bringing in 80 percent of the revenue. This idea of dividing resources depending on the importance of a product is where the real benefit of ABC analysis lies.

Let's stick with our store example and take a look at the spectrum a store manager can use to review items. First off, we have our A items, much like those A grade students in school are our top performers. These are the goods where the annual consumption value is the highest and the ones which generate most of the revenue. At the other end of the spectrum, we have our slow movers, who for simplicity, we'll call our C items. This is where our humble battery would live. In the middle of the spectrum are the items which have a medium consumption value, such as shampoo, which a store manager would need to keep an eye on but is not a product with a high daily demand.

We've shown just three options here, but it's worth noting that ABC analysis is not just limited to these three categories. Most companies use a higher level of granularity which, in practice, looks like the Pareto curve. So, now we know which categories our products fall into, but what does it actually mean to how we work?

Those A items, which generate a lot of revenue, need to be looked after and should have tight inventory control, better sales forecasts, and more secure, prioritized storage areas. Reorders for these items will be more frequent, on a weekly or even daily basis, with the main goal being to avoid stockouts at all costs. On the other hand, a typical inventory policy for C items may consist of having as little as one unit on hand at a time and reordering only when an actual purchase has been made in-store. This approach can lead to stockouts, but as they present both low demand and a higher risk of excessive inventory costs, this is deemed acceptable. For C items, the question should be not how many units you have in-store, but rather do we keep them in-store at all.

All of this sounds great in theory, but where do the limitations of ABC analysis lie? The main problem is that despite its virtues, it is a process that has already been around for multiple decades. While it works fairly well for a disorganized human being to prioritize their work, it is far less useful for a computer, which easily has the power to look at the individual characteristics of each product on its own merit.

So that's an overview of ABC analysis. If you have any questions, please don't hesitate to get in touch. We'll see you next time. Bye for now.

Keywords

ABC analysis
Pareto principle
80/20 rule
Inventory categorization
Supply chain management
Store management
A items
C items
Granularity
Stockouts

FAQ

Q: What is ABC analysis? A: ABC analysis is a simple inventory categorization method that divides items based on their perceived importance, rooted in the Pareto principle.

Q: What is the Pareto principle and how does it relate to ABC analysis? A: The Pareto principle, or 80/20 rule, originated from Vilfredo Pareto's observation that 80% of wealth was held by 20% of the population. This principle applies widely, including in inventory management where 80% of consumption comes from 20% of items.

Q: How are items categorized in ABC analysis? A: Items are categorized into three groups: A items (high consumption value), B items (medium consumption value), and C items (low consumption value).

Q: What action steps are taken for A, B, and C items in inventory management? A: A items require tight inventory control and frequent reorders, B items need moderate attention, and C items often have minimal stock and are reordered only after purchase.

Q: What are the limitations of ABC analysis? A: The main limitation is that while it is useful for human prioritization, it is less effective for computers, which can analyze each item's characteristics individually.