The ABC analysis of inventory is a commonly used inventory categorization methodology. It is rooted in the popular axiom, a small percentage of items contribute most of the revenue/profit, this is a crude translation of Pareto’s principle (also known as 80/20 rule).
The ABC analysis classifies inventory into the most important, or category “A” to the least important category “C”. Of course, many organizations do not stop at “C” but continue to classify into more categories. The general idea remains the same, “A” is most important, followed by “B” and so on and so forth.
Reason why ABC analysis is important
The reason ABC analysis is important and such a prevalent practice in retail is due to its simplicity and also because it reinforces the focus required on the inventory category that contributes most.
How is ABC analysis done
There are a couple of simple factors to consider:
- The first consideration is how to calculate the “score” for each item: There are a few variations that are commonly used. Some organizations simply count the number of units sold, but this method is most suitable, where the variation in price amongst SKUs or products is minimal. The other way to do is to use the revenue generated, which is nothing but units sold multiplied by per-unit price.
- The second factor is the time period we are going to use for the analysis: Most of the retail cycles are impacted by the seasonal nature of the business, for example, the fashion, footwear, and accessories are hugely impacted by the festive season. The period we consider, for the analysis should be significantly large to account for the periods of high or low demand.
Once the above two decisions have been made, it is relatively easy to do the ABC analysis. You can use a spreadsheet if the number of SKUs is relatively small or use a database query or any of the visualization tools to do this analysis. You just need a sorted list of the items with their relative score in the next column.
Once the analysis has been done, you will find the top SKUs or products that drive maximum business for you. Once you have the list of (let’s say 20-30 products), the next step is to align business actions to these select products, for example:
ensure that these products are available to the customer, so these products would warrant a higher service level.
- Price elasticity of demand:
for the items that contribute most, the price elasticity needs to be tuned appropriately. You might have a bit of room to optimize the price for these products.
- A close eye on the performance of the high importance products:
this simply means that the dashboards and any other stakeholders reporting should include filters or views to specifically look at the performance of these products.