What is ABC analysis?

This analysis groups the entire range of materials held in stock into three categories – A, B, and C depending upon their annual consumption value known as “annual usage value.” Annual usage value for an item is the annual monetary value of consumption which can be computed by the following relationship:

Annual usage value = annual consumption in units * unit purchase price

In case of dynamically varying unit prices of materials, it may be obtained by actual money spent on consuming that material in a year – the information captured through stores accounting systems. ABC analysis is the most popular method of selective inventory control and due to its effectiveness has also been called “always better control.”

While conducting ABC analysis, we arrange the annual usage value of items in descending order with the highest usage value at the top. A cumulative graph, as shown in the figure below, is then obtained using this data. A simple computer program will enable you to produce this graph quite conveniently even if the total numbers of items are very large.

ABC curve, shown in the figure below, plots the cumulative percentage of the item on the x-axis and the cumulative percentage of annual usage value on the y-axis. It will be invariably observed that irrespective of the context or the nature of materials, this type of curve will hold. Of course, the 20:80 rule is not to be interpreted as 20.00 and 80.00. Twenty percent could be 18 or 22, and 80 % could be 78 or 84. It is the spirit of the 20:80 rule that is the key insight to be obtained from Pareto’s Law. To identify A, B, and C classes depicted in the figure below, typically the following classification will emerge:

- A class items – These are 10 % top annual usage value items that are responsible for 75 % of the total annual material expenditure. These are the “significant few,” and any rigor of scientific inventory control will be justifiable for such a class of items.

- B class items – Next 20 % of items will be responsible for an additional 20 % annual usage value. These do not require a very thorough control effort and simple or relaxed controls will be adequate.

- C class items – A vast majority of low-end 70 % items will hardly account for 5 % of the total annual usage value. These items constitute “trivial many.” For such items, no scientific approach to inventory control is necessary or even desirable and may be an enlightened commonsense approach.

Thus, it is interesting to note that by just focusing on the top 10 % of annual usage items, we can influence 75 % of the total material expenses in a year, and 70 % of items do not require any rigorous model-based inventory control.

The limitation of ABC analysis is that it groups the items into three categories based on annual usage value only. It does not take note of how critical the item is from the point of view of its availability (shortage cost). Additionally, if the unit purchase price or demand fluctuations are high, the ABC classification needs to be updated frequently. To address this issue, the VED analysis is done based on the criticality of the availability of items.

VED Analysis

ABC analysis does not address the issue of what happens if we do not have materials when required. For a system with a large number of items, it is not feasible to compute the shortage cost for each item. A selective approach to inventory management requires grouping all the items into three categories based on the opportunity cost of shortages. V (vital), E (essential), and D (desirable) analysis attempt to do this. Based on the criticality of the item, VED analysis identifies the items into the following three groups:

- V = vital items; “must” have them in stock when needed.

- E = essential items; “should” have them in stock.

- D = desirable items; “can” have them in stock.

V items have extremely high opportunity cost of shortage, the almost catastrophic impact resulting in complete stoppage of operations, delayed projects, and failed missions. For such items, the risk of shortage has to be extremely low. E category of items has a significant opportunity cost of shortage but is not as high or catastrophic as the V category. In such cases, a relatively bigger risk of shortage is a tolerable category, the shortage cost may be quite low, and hence a still higher risk of shortage can be tolerated.

VED analysis will enable the materials managers to determine the service level desired and eventually the amount of safety (buffer) stock required to achieve that service level. Service level is an indicator of the availability of stock on the shelf when needed. For example, a service level of 0.97 (or 97 %) means that out of 100 demand instances, 97 times the stock was available when required. Thus, the risk of shortage is 3 % for such items. For example, in the inventory control of medicines in a hospital or a chemist's shop, medicines that are lifesaving will come under the V category because their nonavailability could lead to the loss of human life. E-category medicines are those which are essential, but some degree of backlogging is feasible, and delay will not lead to loss of life or alternate substitute may be available. D-category medicines such as vitamins, food supplements, etc., are those where service levels could be low. Similarly in project-related materials planning, all materials required for activities on the critical path can be “V” items. Activities having small “slack” (amount of delay tolerable) can be E category, and materials required for activities having substantial slack can be grouped into D category materials.

ABC-VED Matrix and Service Levels:

ABC analysis and VED analysis attempt to group the items into three categories from two different perspectives. ABC looks at what happens when we have the item in stock, while VED looks at what happens if we do not have the item when required. However, for each item, these twin attributes constitute the two sides of the same coin. In addition, even a C-class item can be vital, and an A-class item could be desirable. The desired “service level” for an item, therefore, depends on the two-way characterization of each item. For example, for a C-class but essential item, the service level must be very high, says 99.99 % because it is inconceivable that for the nonavailability of C-class items such as a “washer,” the entire aircraft remains grounded. After all, maintenance cannot be done due to the non-availability of that “washer” as a spare. However, if an A-class item is vital, maybe a 97 % service level is acceptable. For A-class desirable items, even a 60 % service level is good enough, whereas, for C-class desirable, a service level of 90% may be acceptable.

The table above shows a typical ABC-VED matrix with entries in the cells as an illustrative example of an acceptable service level. It may be noted that these values are for illustration purposes only and intended to convey the message, not to be taken as sacrosanct numbers literally. Thus, all the items are grouped into nine categories based on the two-way classification in the table above. The service levels can then be translated into the buffer stocks required to achieve those service levels.

FSN Analysis

FSN analysis is based on the popularity of an item in terms of the frequency of its demand from the store. It is based on analyzing the consumption pattern. The three categories are as follows:

- F – Fast-moving items, which are required very frequently.
- S – Slow-moving items, which are demanded very occasionally.
- N – Non-moving items or dead stocks, which have not been demanded for a long period in the past 2 years.

* FSN analysis helps choose the appropriate type of inventory models. Classical inventory models such as the EOQ model, and ABC analysis are applicable only for the F (fast-moving) items. These models do not apply to slow-moving or non-moving items.

* S: Slow-moving materials are characterized by infrequent demand and are typical in the management of some expensive engineering spares and materials required for project implementation. Inventory models for slow-moving materials are quite different from the classical ones in conventional inventory control textbooks.

* N: Inventory management of non-moving materials is to be seen as “inventory control in the reverse gear.” The problem is not “how much to buy” or “when to buy,” but “what to do with what has already been bought.” Hence, the management of dead stock (as non-moving materials are generally called) primarily deals with optimal surplus disposal policy, recycling, and reuse.

How to implement ABC analysis? 

The mechanism of classifying items into “A, B, C” categories are described in the following steps:

- Calculate LE annual issues for each item in inventory by multiplying the unit cost by the number of units issued in a year. It is assumed that the issues and consumption are the same.

- Sort all items by LE annual issues in descending sequence.

- Prepare a list from these ranked items showing item no., unit cost, annual units issued, and annual LE value of units issued.

- Starting at the top of the list, compute a running total, item-by-item issue value, and the LE consumption value i.e., the cumulative cost of the items.

- Compute and print for each item the cumulative percentages for the item count and cumulative annual issue value.

Sometimes, even plotting the ABC curve may take time for data gathering particularly if the situation has a very large number of parts and computerization of the materials management function has not started. In such a case, the following thumb rule based on the average Pareto curve:

Let X = average annual usage value/item/year
          = total amount of money spent in the year on materials consumed / total number of materials consumed in the year

X requires overall macro-level information at the enterprise level and hence should be easily available. Then,

- A class are those items where the annual usage value is ≥ 6X.
- C class are those items where the annual usage value is ≤ 0.5X.

Items which are neither A nor C must be B class. This thumb rule may give a rough and ready basis to group items into A, B, and C and can be fine-tuned later when data are available to plot the ABC curve. For example, if an organization is spending 10 million LE on 1,000 SKUs in a year X = 100,000 LE/item/year, then A class items are all those where they are spending LE 600,000/year or more. C-class items are those where less than 50,000 LE/year is being spent.

Hence, you must remember the basic principles in A-B-C analysis are:

- the analysis does not depend upon the unit cost of the items but only on its annual consumption value

- it does not depend on the importance of the item

- limits for A-B-C categorization are not uniform but will depend upon the size of the undertaking, its inventory as well as a number of items controlled.

Combination of A-B-C and V-E-D Analysis: 

A combination of A-B-C and V-E-D analysis can be gainfully employed to evolve meaningful control over the material supplies.

Model 1

Model 2

- Category I includes all vital and expensive items. These require close monitoring and strict control. 

- Category II covers items of the essential category and they are less expensive.

- Category III comprises the desirable and cheaper group of items.

Advantages of effective ABC analysis:

A long list of benefits can result from applying ABC analysis to inventory management, including

- Increased Inventory Optimization: 

The analysis identifies the products that are in demand. A company can then use its precious warehouse space to adequately stock those goods and maintain lower stock levels for Class B or C items.

- Improved Inventory Forecasting: 

Monitoring and collecting data about products that have high customer demand can increase the accuracy of sales forecasting. Managers can use this information to set inventory levels and prices to increase overall revenue for the company.

- Better Pricing: 

A surge in sales for a specific item implies demand is increasing and a price increase may be reasonable, which improves profitability.

- Informed Supplier Negotiations:

 Since companies earn 70% to 80% of their revenue on Class A items, it makes sense to negotiate better terms with suppliers for those items. If the supplier will not agree to lower costs, try negotiating post-purchase services, down payment reductions, free shipping, or other cost savings.

- Strategic Resource Allocation:

 ABC analysis is a way to continuously evaluate resource allocation to ensure that Class A items align with customer demand. When demand lowers, reclassify the item to make better use of personnel, time, and space for the new Class A products.

- Better Product Life Cycle Management:

 Insights into where a product is in its life cycle (launch, growth, maturity, or decline) are critical for forecasting demand and stocking inventory levels appropriately.

- Control Over High-Cost Items: 

Class A inventory is closely tied to a company’s success. Prioritize monitoring demand and maintaining healthy stock levels, so there’s always enough of the key products on hand.

- Sensible Stock Turnover Rate:

 Maintain the stock turnover rate at appropriate levels through methodical inventory control and data capture.

- Reduced Storage Expenses:

 By carrying the correct proportion of stock based on A, B, or C classes, you can reduce the inventory carrying costs that come with holding excess inventory.

- Simplified Supply Chain Management:

 Use an ABC analysis of inventory data to determine if it’s time to consolidate suppliers or shift to a single source to reduce carrying costs and simplify operations.