Using ABC Analysis for Inventory Control
By Carleen Wong, CPIM
The first step in determining an inventory situation is to use
a technique called ABC analysis. It is an inventory control method
based upon a statistical principle discovered by a 19th century
economist, Vilfredo Pareto. He observed that a small number of
situations in a population would often dominate the results achieved.
Therefore, controlling the vital few would go a long way to controlling
the whole. This observation is known as the “Management Principle
of Materiality” and is recognized today as Pareto’s Law.
When ABC analysis is applied to an inventory situation, it determines
the importance of items and the level of controls placed on the
item. By dividing a company’s inventory into different classifications–
A, B, C; managers can focus on the items that account for the
majority of the inventory. The adaptation of Pareto’s Law of the
vital few and trivial many follows a pattern:
- A inventory accounts for about 20% of the items and 80%
of the dollar usage
- B inventory accounts for about 30% of the items and 15%
of the dollar usage
- C inventory accounts for about 50% of the items and 5% of
the dollar usage
These percentages are approximate and vary from company to company.
Normally the classifications are based upon annual dollar usage,
but other criteria can be used, such as transaction usage, unit
cost, lead time, and others.
The steps in doing the ABC analysis are: determine annual quantity
usage of each item, multiply the annual quantity usage by the
cost of the item to get the total annual dollar usage, add the
total dollar usage of all items to get aggregate annual dollar
inventory expenditure, divide the total dollar usage of each item
by the aggregate inventory expenditure to reach the percentage
of total usage for any item, list the in rank order by percentage
of aggregate usage, and review annual usage distribution and classify
items as A, B, or C.
When doing an ABC classification, separate analysis should be
performed for different types of inventory. ABC analysis provides
the means for identifying those items that make the largest impact
on a company’s overall inventory cost performance. Different controls
are used for each classification to improve inventory performance.
‘A’ items have tighter controls on inventory records and more
frequent reviews of forecasting, demand requirements, order quantities,
safety stocks, and cycle counts. ‘B’ items have similar controls
to ‘A’ items but reviews are less frequent. ‘C’ items have the
simplest controls. They are only important if there is a shortage
of one of them. Thus, ‘C’ items can be ordered in larger quantities
and have higher safety stocks.
ABC analysis puts emphasis on “where the value is”. By focusing
efforts on higher value inventory, a company can assign proper
resources to attain the optimum inventory levels, reducing inventory
costs, and ensuring customers’ needs are met.