ABC Analysis and Why It's Needed for Your Business

ABC Analysis and Why It's Needed for Your Business

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Dealing with thousands of products and dozens of suppliers, you need to know how to prioritize the inventory process. ABC analysis comes to the rescue for both modern businesses, like, and more old-fashioned brands. Here's how it works in practice.

What Is ABC Analysis and XYZ Analysis

ABC analysis (Always Better Control) is a method of ranking business resources according to their importance. It determines the most marketable products and the profitability of products as a whole. ABC analysis allows you to effectively control and allocate resources, reduce obsolete inventory and increase sales.

Some products are cheaper, others are more expensive. For some products, demand is constant; for others, demand is seasonal. ABC inventory analysis helps to classify the entire merchandise assortment to understand which products bring the company the most revenue and which ones it's time to remove from sales.

ABC analysis groups elements into three categories (A, B, and C) based on their value to the business.

ABC analysis is based on Pareto's law. It states that in most cases, 20% of the effort yields 80% of the result. The 20 by 80 rule also works in ABC analysis: 20% of goods make 80% of a company's turnover.

ABC analysis allows you to classify by importance:

  • Assortment.

  • Suppliers.

  • Stocks.

  • Customer activity.

  • Any other business resources with sufficient statistical data.

ABC classification prioritizes sales organization, reduces time spent on purchasing and inventory management.

But ABC analysis is too simplistic because its categories are static and their evaluation criteria are one-dimensional.

To get more reliable data, XYZ analysis is used. It segments goods depending on the demand for them over a certain period of time.

Its analytics is based on the change of sales volume from month to month. For each commodity the coefficient of variation (hereinafter - CV) is derived, which shows the variation of demand in a certain period. The components of XYZ analysis:

  • X - Regular Demand. Stable goods by demand (CV from 0% to 10%);

  • Y - Volatile Demand. Average, as a rule - goods with seasonal demand (CV from 10% to 25%);

  • Z - Irregular and Hard-to-predict Demand. Goods with occasional demand (CV from 25% and above).

XYZ analysis is an additional method of analytics to ABC-analysis, which allows companies to make more reasonable decisions in the process of organization of sales and storage of inventory. For example, it's more reasonable to sell AX-goods (valuable with constant demand) than AZ-goods (with unstable demand).

What ABC Analysis Shows and Where It's Applicable

ABC analysis has two purposes:

  • To focus attention on priorities - top assortment positions;

  • To determine unprofitable or low-profitable groups of goods to remove them from the assortment portfolio.

It's advisable to conduct an ABC analysis at least once a year, ideally quarterly. You can also run it monthly, but the short period doesn't always provide a complete picture to track the dynamics of the situation and make the right decision.

ABC analysis sorts goods into three categories:

  • Category A - the best-selling products that bring in the most revenue for the company. These products account for 20% of the entire assortment and generate 80% of sales. It's essential, sometimes critical to the business. Category A needs to be carefully monitored, with maximum investment and the best resources.

  • Category B - products that sell regularly, but are less in demand than A-products. Have an average cost, relatively less market demand, but provide stable sales. Make up 30% of the assortment and make 15% of sales.

  • Category C is the bottom rung of the sales ladder. This includes items that don't sell well (make about 5% of sales), but make as much as 50-60% of the assortment. This is "dead weight," which doesn't benefit the business, so it should be "parted" with no regrets.

What Are the Benefits of ABC Analysis?

The main advantage of ABC-analysis is the rapid identification of the best-selling goods. As a result, it's possible to predict their availability to avoid shortages. Thanks to ABC analysis, businesses can focus on high-priority products and maximize profits.

Other benefits of ABC analysis:

  • Accurate demand forecasting for best-selling products.

  • Quality management of warehouse inventory.

  • Pinpoint improvement of the supply chain (working with the best suppliers).

  • Reduction of costs for purchasing and storage of unprofitable products.

  • Optimization of pricing strategy.

  • Increase of through sales coefficient.

But there are also disadvantages:

  • A-category systematic control is required - one must constantly analyze the product line, checking whether all A-products are still highly profitable.

  • The method doesn't work with qualitative characteristics - if different types of consumer goods are ranked, each group must be analyzed separately.

  • ABC analysis lacks accuracy - classification is based solely on the monetary value of goods, other factors: seasonality, fluctuations in demand, purchasing power - are ignored.

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