What is ABC Analysis?

ABC Analysis also referred to as ABC Classification, is an integral part

of material management. It is an inventory categorization method,
which classifies the inventory primarily into three distinct categories
based on the revenue generation. ABC inventory helps business
entrepreneurs and stock owners identify the essential products in the
stock and prioritize their management based on the value. The
inventory analysis is based on the Pareto Principle. 

The Pareto Principle is a popular economic theory, discovered by

renowned Italian economist Vilfredo Pareto. Pareto believed that
optimum economic growth occurs only due to a small part of the
economy. It means that the relation between the input and output is
always unequal. 

Pareto Principle states that 80% of the sales volume gets generated
from the top 20% of the items. It says that in any group, there are
significant few and insignificant many. It is also known as the 80/20
rule. 

Category of ABC Analysis 

ABC Analysis is based on the theory that all inventory items cannot
have similar or equal value. Hence, the three categories include-
If one implements the Pareto Principle to ABC Analysis, then A consists
of 20% of the total products with almost 80% revenue generation.
Hence, it demands a robust and consistent control. B regulates
approximately 30% of the goods with 15% revenue, while C has the
lion's share controlling almost 50% of the stock but only powering 5%
of the total revenue. Hence the stock managers are quite lenient while
calculating this category of inventory. 

ABC Analysis Graph 

The two pyramids represent the ABC Analysis Graph.
 

The first pyramid suggests the percentage of the total number of

inventory items. Here Category A comprises only 10% of products, B
contains 20% items, and C has the maximum number with 70% of
products.
Similarly, if one perceives the second pyramid representing the
percentage of average inventory value, the structure reverses. Here, A
gains the spotlight with almost 70% of inventory value and revenue
generation, while B retains its mid-level spot controlling 20% of
inventory value. C only generates 10% of revenue; hence it has limited
control. 

In short, A signifies most important, B indicates moderately

necessary, and C denotes least essential inventory goods. 

How to Calculate ABC Analysis? 

A stock manager can perform ABC calculations on both individual
product groups or a wide range of inventory. An ABC Calculation is
usually carried out within five steps, which are as follows-

1. First, multiply the annual number of products with each item's

cost and find the utility of that product.
2. Make a category of every product in the descending order based
on its usage value. 
3. Add the usage value of the products, including the total number
of items. 
4. Find out the cumulative percentages of items sold and annual
consumption value. 
5. Now, it's time to divide your data into three categories, finally, in
an approximate ratio of 80:15:5. 

Example of ABC Analysis 

ABC calculation has been further illustrated through an example

containing a few tables. 

One can take the example of a Furniture Store.

Step 1: Multiply the total number of items by the cost of each unit to
find the annual usage value. 
Step 2: After noting all the products of the inventory, it’s time to list
them in the descending order based on annual consumption value. 
Step 3: Sum up and add the total number of units sold and the annual
consumption value. 
Step 4: Find out the cumulative percentage of products sold along
with the percentage of annual consumption value. 
Step 5: In the last step, split the data and numbers into the three A, B,
and C categories. Remember, it’s essential to set the data in the ratio
of 80:15:5. 
The table shows that items listed in Category A generate
approximately  79% of annual consumption value, B yields 13%, while
C generates 8% revenue.
The Salient Features of ABC Analysis

It’s essential to highlight the pivotal features of all the three categories
viz—A, B, and C on a separate note. Have a look at the image below. 

Why is it Critical to Use ABC Analysis for Inventory

Management?

Many organizations have massive Stock Keeping Units or SKUs, but it

hasn't helped them to flourish and upscale their business.
Furthermore, there are various other inventory
management challenges that a business entrepreneur has to tackle. It
may include inadequate knowledge about the stock, inefficient
management process,  finding problems in managing people and
space, and more.
Inventory classification is a viable solution that can help enterprises
streamline their inventory management process. As the name
suggests, inventory categorization is a method to strategically set the
price of various products based on their demand value. The ABC
method of inventory is a classification technique that helps stock
managers resolve all concerns related to maintaining inventory and
maximize the inventory value of the goods. 

1. Analyze the Customer Demand for a Particular Product

Category

Every product must pass through four main stages; launch, growth,
maturity, and then declination. When a product gains optimum value,
it inevitably sinks at a certain point in time. It is known as the lifespan
of a product. 

It is essential to note that the lifespan of a product depends on the

customer demands. It is here that ABC inventory classification gains
the spotlight as it helps business enterprises in precisely analyzing
customer demands. The business owners and inventory managers can
analyze the consumer needs of a specific product and manage their
inventory accordingly. If the market for an item escalates, the downfall
period gets pushed further.

2. Streamlining  and Optimizing the Inventory Process

One of the significant. Unique Selling Points or USPs of ABC Analysis is

streamlining and optimizing the inventory management process. It
helps inventory managers to organize and segregate stock based on
their annual consumption value and revenue generation. The products
can also be categorized based on customer demands. 

3. Conducive Negotiation with the Supplier

ABC Analysis is also useful in getting a conducive negotiation with the
supplier. For example, if an enterprise is negotiating with the suppliers
of A category products, it has to make a maximum investment there
since it offers maximal revenue. Even if the business is making a
lucrative offer, there are chances that the supplier is still unwilling to
strike the deal. 

In such a scenario, the business can still seal the deal by offering other
benefits such as lowering the down payment and providing free
shipping. It helps to create a favorable win-win situation for both
parties. It also allows businesses to save more on A category products
and reaping more profits. 

4. Strategic Pricing of the Products 

ABC inventory analysis also allows organizations to set the price of

various products strategically. It enhances the inventory value of the
products. Once the cost of the products is set strategically, it becomes
relatively easier to align them based on different categories. If the
demand for the product increases, the seller can hike the price. 

5. Enhancement in Customer Service Levels

The warehouse managers can stock the products based on their value
and importance. It means that they do not need to overstock any such
items that are not sold regularly and have a low margin.  Here, ABC
Analysis can play a pivotal role in helping inventory managers set
service levels based on categorizing the items. It further streamlines
the supply chain management process. 

6. The Allocation of the Resources

An inventory manager has to give a special status to A-class items and
focus on that specific category. But if he finds that the demand for A
category items has reduced and that it is no longer generating higher
revenue, the products are demoted to a lower category. 

How to Conduct an ABC Analysis?

A business organization can conduct a precise ABC Analysis by

ensuring the following steps-

 Find out what needs to analyzed and anticipate the success

ratio

When a business conducts an ABC Classification, it has two prime

objectives. First, to ensure that supply costs are highly competitive and
second to boost the cash flow by storing high demanding products in
the stock. 

 Gathering Data for Analyzing 

If the company uses an inventory management system or accounting

software, it can easily collect vital data related to various stock items.
Plus, it can also gather information on its annual expenditure, orders
and purchases, transportation costs, and more.

 Rank the Inventory in Descending Order

Next, it's essential to classify or organize the inventory in the

descending order. Place the maximal-priced product on the top and
the minimal-priced item at the bottom. Even during cycle counting - a
process where high inventory accuracy can be maintained throughout
the year can be done using the ABC method.

 Calculating the Cumulative Impact

Now make a note of all the products and add them in a spreadsheet.
It's time to calculate their cumulative effect on the business. The
products are divided into two columns; the total number of products
sold and their annual costs. Take out the cumulative percentage of
annual usage value to categorize the inventory. 

 Classify the Inventory Based on the Demand

It is at this stage that one needs to apply the Pareto Principle. It's not
necessary to use the 80/20 rule, but it's essential to take a few pivotal
measures. The steps include conducive negotiation with the suppliers,
framing a product price strategy, ensuring the optimal value of the
products, and more. 

 Monitor the Categories and Allocate the Products

Accordingly

It is the last step where managers have to keenly analyze the

categories and then allocate the products based on revenue
generation. It means that an item minting the highest money will peak
the class. But it contains only a few product sources. On the other
hand, the ones providing lower returns will drop down the list. 
Besides that, the managers need to continuously keep an eye on
pricing, customer demand, and product performance. 

Major Applications of ABC Analysis

The Manufacturing Sector

ABC  Inventory Analysis helps manufacturers to improve the inventory

replenishment schedule. It allows managers to categorize stock items
based on the total annual cost. Also, ABC Analysis becomes mandatory
if the organization plans to integrate the Kaban to manage the
workflows. 
Supply Chain and Warehouse

The supply chain and warehouses use ABC Inventory Classification

mainly for the stock count cycles. For instance, items placed in
category A have to be counted quarterly. B class items need a bi-
annual counting. On the other hand, C category products get the most
liberty. They are calculated on an annual basis, once in a year. 

Retail and E-commerce

The retail and the e-commerce industry usually choose ABC

Management for customer segmentation. It helps retailers and e-
commerce owners to pinpoint their most valuable customers. ABC
Analysis is performed using key metrics such as sales revenue, buying
potential, and contribution margin. The retailers can create a chart
based on the metrics and then rank their customers in A, B, and C
categories accordingly. 

Logistics Industry

The logistics industry is also reaping the benefits of ABC Analysis. Here
ABC management plays a pivotal role in controlling the inventory. The
products are classified according to their importance based on
different criteria such as sales ratio, profit margin, and cost of
transportation, etc.  

Future Trends in ABC Analysis 

The business enterprises today are operating more in a data-driven

era powered by digital transformation, Inventory management has
already upscaled and potentially escalated; all thanks to the best free
and open source inventory management software. But the innovative
technologies are also playing a dominant role in modernizing and
upgrading the ABC method of inventory.

It is interesting to note that futuristic trends such as Big Data, the

Internet of Things, and AI to replenish data. For instance, ABC
Inventory System with multiple criteria is using the Artificial
Intelligence-based inventory classification process. 

Future driving trends will help managers to make a more accurate and
complete inventory analysis with data transparency. Furthermore, it
will also allow them to save a  lot of their valuable time and labor
costs.  

Also, it is interesting to note that ABC Analysis is no more restricted to

inventory management and supply chain business. Even large service
sector organizations such as healthcare firms and retail banks have
started to use ABC Analysis successfully. It is expected that more
industries will join the party within the next few years. 

ABC Classification indeed offers a plethora of benefits, but it has a few

limitations as well. It consumes much of the valuable time and effort
as all inventory items have to be divided into three categories based
on its value. Also, the ABC inventory system is based on the monetary
value of the products and ignores all other factors. 

One of the best ways to resolve all these issues is to implement

an inventory optimization software that can automate and streamline
the entire process. 

Conclusion 

ABC Analysis is one of the best ways business entrepreneurs and

inventory managers can classify their stocks based on their value and
revenue generation. The ABC method of inventory allows them to
focus on essential products and monitor their pricing. It also helps to
keep the inventory under control, and businesses can plan their
expenditures accordingly. 

Also, if you are interested in investing in viable and futuristic inventory

management software, then please go through the inventory
management software buyer’s guide, where you will find a
comprehensive overview of the software, including its vital features
and advantages. 
 VED Analysis
Meaning of VED Analysis
VED analysis is an inventory management technique that
classifies inventory based on its functional importance. It
categorizes stock under three heads based on its
importance and necessity for an organization for
production or any of its other activities. VED analysis
stands for Vital, Essential, and Desirable.

Table of Contents

1. Meaning of VED Analysis

1. V-Vital category
2. E- Essential category
3. D- Desirable category
2. Importance of VED Analysis
1. Item cost
2. Ordering / Set-up Cost
3. Holding Costs
4. Stock Out Cost
3. Usage of VED Analysis
4. Summary
V-Vital category
As the name suggests, the category “Vital” includes
inventory, which is necessary for production or any other
process in an organization. The shortage of items under
this category can severely hamper or disrupt the proper
functioning of operations. Hence, continuous checking,
evaluation, and replenishment happen for such stocks. If
any of such inventories are unavailable, the entire
production chain may stop. Also, a missing essential
component may be of need at the time of a breakdown.
Therefore, order for such inventory should be before-
hand. Proper checks should be put in place by the
management to ensure the continuous availability of
items under the “vital” category.

E- Essential category
The essential category includes inventory, which is next
to being vital. These, too, are very important for any
organization because they may lead to a stoppage of
production or hamper some other process. But the loss
due to their unavailability may be temporary, or it might
be possible to repair the stock item or part.

The management should ensure optimum availability and

maintenance of inventory under the “Essential” category
too. The unavailability of inventory under this category
should not cause any stoppage or delays.

D- Desirable category
The desirable category of inventory is the least important
among the three, and their unavailability may result in
minor stoppages in production or other processes.
Moreover, the easy replenishment of such shortages is
possible in a short duration of time.
Importance of VED Analysis
It is of utmost importance to any organization to
maintain an optimum level of inventory. Maintaining
inventory has its costs, and hence, this analysis
bifurcates inventory in three parts to help in managerial
decisions on inventory maintenance. There are four types
of costs to maintain stock which are:

Item cost
This is the cost or price of the inventory items. It is the
actual purchase value of holding stock. Therefore, it will
be high with more inventory and vice-versa.

Ordering / Set-up Cost

The purchase of inventory involves certain costs. These
may include transportation charges, packing charges,
etc.

Holding Costs
After the purchase of inventory items, there are a few
costs too. These may be related to storage, insurance
charges of stock or inventory, labor costs associated with
the handling of stock, etc. Moreover, it includes any
damage, leakage, or pilferage of the stock in hand.

Stock Out Cost

These costs are the result of an inventory item running
out of stock. It includes loss of production due to a spare
part getting out of stock. Moreover, this may delay the
product sale. Also, the product itself may get out of
stock. Such losses are a part of the stockout cost.

VED analysis is a crucial tool to understand and

categorize inventory according to its importance. Because
of it, the management can optimize costs by investing
more in the vital and essential categories of stock and
lesser in the desirable category of inventory.

Usage of VED Analysis

Small and big organizations both widely use VED
analysis. The most important application of this analysis
is in maintaining medical inventory in hospitals and their
drug stores. Drugs and related supplies comprise a
significant portion of a hospital’s budget. Moreover,
maintaining the right quantity of the right drugs is an
extremely challenging task for management. While a
shortage of critical medicine can lead to crises and even
loss of lives, an abundance of non-important medications
can lead to blockage of money and space, both.

VED analysis helps in dividing medicines into the three

categories as per their usage and importance. Therefore,
medication in the vital group is to be kept in stock
compulsorily, as they would be critical for patients.
Medicines which are a bit less risky, or which can be
obtained from other sources too at short notice, become
part of an essential category. Those that are least critical
and their shortage will not pose any danger to a patient’s
health, and lives get its place in the desired class. As a
result, the hospital’s management can wisely allocate
resources on medical inventory as per their respective
VED categories.

Summary
Resources are always scarce for any organization, and
thus optimum utilization of available resources is the key
to success. Since costs related to maintaining inventory
are high, it becomes the responsibility of the
management to tackle these costs effectively. Scientific
methods like VED analysis help in maintaining an
optimum level of stock, without posing risks of shortages
or non-availability of essential spares, parts, or products.