Meaning of ABC Analysis
Every firm has a large variety of inventories in its stock room. Each inventory will have a particular use. The flow of inventory should be in a well-defined manner so that there is no wastage or overflow of inventories in the firm. To ensure that the appropriate amount of inventory is available in the organization inventory control is practiced in most organizations. There are different types of techniques used in inventory management. They include batch tracking, economic order quantity, demand forecasting, etc.
The foremost important technique is ABC Analysis. What is ABC Analysis? Why is it important in an organization? What are the different types?
Everything is better when it is controlled and organized. Inventory will have a lot of importance in the firm. ABC analysis colloquially known as Always Better Control is a technique in which all the inventories are categorized based on their priority in the business. Each category is differently handled and managed according to the level of importance. The inventory is mainly classified into 3 categories :
|A||Items of utmost importance and high market value for the items constitutes 10-20% of total inventory value but the annual consumption may be up to 80%.|
|B||Important but not as important as A and has relatively lesser market demand. Constitutes 30% of the total inventory value and the annual consumption can move up to 20% depending on the consumption of category A.|
|C||Marginally important products : They need the least attention as they are not sold much. Constitutes 50% of the total inventory value and has the least annual consumption i.e., 5%|
Categorization should be done scientifically as there should not be any misinterpretation of data. ABC Analysis should be done accordingly so there is no wastage of inventory and chance of risk in the firm. The following steps help in the best allocation of inventory based on ABC analysis:
- Determine the inventory value of each product mathematically : This is done by multiplying the cost of each inventory by their respective consumption volume.
- Sorting: In this stage, the inventories are sorted in descending order i.e., highest inventory value to lowest.
- Calculate the annual contribution: This is done by dividing each of the inventory values obtained in the first step by total inventory values.
- Grouping: The final step is grouping the inventory value based on the annual contribution to the market.
For instance, let us say a shoe manufacturing company produces a wide variety of shoes. Some shoes are daily worn, some are seasonal, some are informal, etc.
By ABC analysis we can categorize the fasted moving shoes, i.e., with the highest demand and current trends like daily wear in category A. Seasonal wear is usually categorized in B as they have demand, but we should wait for the right time for market introduction. The final products left out are categorized in C. They have relatively lower sales than other categories.
After this example we are left with the question how ABC analysis benefits the firm. There are many ways in which it plays an important role in inventory control.
Objectives and Benefits
- The first and foremost objective or feature of ABC analysis is the determination of the expected return from each inventory.
- ABC analysis helps in having better control over the working capital of the firm.
- Cost minimization can be done as the inventories return is calculated.
- The Pareto principle, also known as the 80/20 rule, is the rule used in ABC analysis. According to this rule, it is said that 80% of income is generated from 20% of the inventory. That is the reason why 80% is a composition of the items in category A.
- Business efficiency is improved at a higher rate as the areas of importance are known and there is no such wastage of resources. All resources are optimized, and the expected return is also known.
- The categorization helps the business to quickly understand data as there is abundant data in the business. Every inch of the data can be scrutinized according to its importance in the work.
- It plays a vital role in the pricing of the products. As we know that certain products have higher demand in the market they can be sold at a higher price.
- There will be much lesser warehousing charges as the inventories are produced according to the market demand.
- There is a higher customer relationship for the firms with ABC analysis as their needs are satisfied.
ABC analysis helps in producing a continuous supply of products to the market as the market is always monitored and the demand is forecasted. There are certain limitations for the same, like:
- High investment of time and effort to categorize these data.
- Market demand can change at any time. If a product falls from B to C the products already produced will be a loss to the firm.
- If the company has an equable annual consumption value of inventory, then ABC analysis cannot be practiced.
In short, we can conclude that ABC Analysis is a strategic approach to classifying a large amount of data into smaller groups for profit maximization and optimization of resources. It is the best way to understand the value of each inventory in the firm and improve the efficiency of the organization. Thus, ABC analysis is a general guideline that is followed by the firms to yield the most profit.