What is ABC Analysis?

ABC analysis is one of the known inventory classification methods available in which inventory is categorized in three classes A, B and C where A being most important, B being important and C being less important. ABC analysis is also known as Pareto Analysis, Pareto rule or 80/20 rule.

ABC analysis must not be confused with Activity Based Costing which is also termed as ABC.

In ABC Inventory analysis, products are categorized on the basis of their importance to the entity rather than their quantity in the warehouse. Importance on the other hand can be judged in difference ways like:

1. Sales revenue generated by each product
2. Contribution made by each product
3. Level of investment or simply cost incurred on each product
4. NRV of each product
5. Turnover period of each product

Its up to the management to decide what basis to use for classification but mostly sales revenue or cost basis are used for ABC. One thing to remember however is that inventory is not just stock as it can be anything like creditors, debtors, investments etc. So the use of word inventory is little generic in this analysis and not specifically meant to be units produced or purchased. We can classify debtors on the basis of debt. Similarly we can classify creditors on the basis of amount owed to them.

The main reason why importance based classification so important is that organizations must concentrate more on those items that are more valuable and prove more worthy to entity. For example if entity’s offering many different products to customers is analysed on sales revenue generated by each product, it is observed that the products generating majority of revenues are in minority like, 10% of total units sold generate 90% of revenue.

Understanding what is important and then reinforcing efforts in that direction will benefit entity even more therefore, ABC analysis helps management in identifying such elements.

Have a look at the following data where we know about 49 different products an entity sells with their sales value:

Serial Number	Amount
1	20,000
2	17000
3	14450
4	12283
5	10441
6	8875
7	7544
8	6412
9	5450
10	4633
11	3938
12	3347
13	2845
14	2418
15	2055
16	1747
17	1485
18	1262
19	1073
20	912
21	775
22	659
23	560
24	476
25	405
26	344
27	292
28	248
29	211
30	179
31	152
32	129
33	110
34	94
35	80
36	68
37	58
38	49
39	42
40	36
41	31
42	26
43	22
44	19
45	16
46	14
47	12
48	10
49	9

Ordinarily all 49 are given equal care which in fact is not necessary and might be detrimental to entity. If we find the total of sales from all 49 products we find it to be 133,296

To conduct ABC analysis we need two more columns i.e. one in which cumulative sales are calculated and second that gives the percentage total:

Serial Number	Amount	Cumulative Sales	Percentage
1	20,000	20,000	15.00%
2	17000	37,000	27.76%
3	14450	51,450	38.60%
4	12283	63,733	47.81%
5	10441	74,174	55.65%
6	8875	83,049	62.30%
7	7544	90,593	67.96%
8	6412	97,005	72.77%
9	5450	102,455	76.86%
10	4633	107,088	80.34%
11	3938	111,026	83.29%
12	3347	114,373	85.80%
13	2845	117,218	87.94%
14	2418	119,636	89.75%
15	2055	121,691	91.29%
16	1747	123,438	92.60%
17	1485	124,923	93.72%
18	1262	126,185	94.67%
19	1073	127,258	95.47%
20	912	128,170	96.15%
21	775	128,945	96.74%
22	659	129,604	97.23%
23	560	130,164	97.65%
24	476	130,640	98.01%
25	405	131,045	98.31%
26	344	131,389	98.57%
27	292	131,681	98.79%
28	248	131,929	98.97%
29	211	132,140	99.13%
30	179	132,319	99.27%
31	152	132,471	99.38%
32	129	132,600	99.48%
33	110	132,710	99.56%
34	94	132,804	99.63%
35	80	132,884	99.69%
36	68	132,952	99.74%
37	58	133,010	99.79%
38	49	133,059	99.82%
39	42	133,101	99.85%
40	36	133,137	99.88%
41	31	133,168	99.90%
42	26	133,194	99.92%
43	22	133,216	99.94%
44	19	133,235	99.95%
45	16	133,251	99.97%
46	14	133,265	99.98%
47	12	133,277	99.99%
48	10	133,287	99.99%
49	9	133,296	100.00%

If we investigate on ABC basis using the revenue contributed by each product we find that out of 49 only 7 products are making up 70% of entity’s revenue. In other words roughly 14% of the total products are generating 70% of revenue and thus considered most important and requires close attention. These 6 products will be classified as “A”.

On the same basis we can find the products that belong to category B and C.

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