Why Companies Perform an ABC Analysis and How It Improves Operations

In inventory management, not all items are created equal. Some have a far greater impact on revenue, cost, or operational efficiency than others. To effectively prioritize resources and make informed decisions, many companies perform an ABC analysis of their inventory.

What is an ABC Analysis?

ABC analysis is a method of categorizing inventory items into three groups based on their importance. The factor used to determine their performance can be the cost of inventory, sales revenue, gross margin contribution, usage frequency, or any other measure relevant to the business. I tend to use a factor of “usage value” since that blends the speed at which inventory is used in addition to the unit cost of the item. 

  • A Items: These typically represent the top 10–20% of items but 70–80% of inventory value.

  • B Items: These usually make up 15–25% of items and 15–25% of inventory value.

  • C Items: These can represent 60–70% of items but only 5–10% of inventory value.

Why Do Companies Perform an ABC Analysis?

1. Focus on What Matters Most

With hundreds or thousands of SKUs in inventory, it’s inefficient to manage every item with the same level of attention. ABC analysis allows businesses to focus their energy, resources (people and cash flow), and controls on the items that have the greatest impact on profitability.

2. Improve Inventory Accuracy

High-value A items require strict inventory control because errors can be costly. ABC analysis supports targeted cycle counting, where A items are counted more frequently than B or C items, improving accuracy where it matters most.

3. Optimize Replenishment Strategies

Different items require different ordering and stocking approaches. A-items may warrant tighter reorder points and safety stock settings, while C items may be ordered in bulk to reduce handling costs. ABC analysis enables differentiated replenishment strategies. If you manufacture your own finished goods, you may wish to classify the raw materials of your A-item finished goods as A.

4. Reduce Inventory Costs

By identifying low-value, slow-moving C items, businesses can avoid overstocking items that tie up capital and take up storage space. ABC classification helps identify candidates for phase-out, discounting, or more efficient ordering.

5. Enhance Supplier Management

Companies often apply more rigorous sourcing and quality control for A items, given their critical importance. Supplier agreements, lead times, and terms can be customized based on the classification.

What Do Companies Do with the Results of an ABC Analysis?

After completing an ABC analysis, companies typically take the following actions:

1. Set Differentiated Inventory Policies

  • A Items: Frequent reviews, tighter inventory controls, strong supplier relationships.

  • B Items: Periodic reviews, balanced stock levels.

  • C Items: Simplified controls, possibly bulk ordering, or reduction strategies.

2. Implement Targeted Cycle Counting

  • Schedule frequent counts for A-items (monthly or weekly).

  • Count B-items quarterly.

  • Count C items annually or randomly.

3. Reallocate Resources

  • Assign top analysts or purchasing agents to manage A-items.

  • Automate or batch manage C items.

4. Review Product Mix

  • Analyze whether C items are still necessary, or if consolidation is possible. If a C-item is a raw material, see if it can be phased out and replaced with another item. This latter action is usually part of a SKU rationalization exercise.

  • Use A-item performance to guide product development, marketing, or bundling strategies. This refers to A-items that are finished goods.

5. Support Demand Planning and Forecasting

  • Apply more precise forecasting methods to A-items.

  • Use broader estimates or trend-based methods for C-items.

Conclusion

ABC analysis is a foundational tool for inventory management that helps businesses apply the Pareto Principle, focusing on the few items that drive most of the impact. When applied correctly, it enables better control, reduces carrying costs, and improves decision-making across procurement, warehousing, and sales.

Companies that leverage ABC analysis often find they can reduce waste, increase service levels, and strengthen their bottom line all by understanding the true value distribution within their inventory.

Finally, if you’re a company who is struggling with ongoing inaccuracies in your inventory records (I work with several), an ABC analysis will help you determine which items to keep counting (i.e., cycle-count the A group) while the root causes of your inaccurate records are being investigated and resolved.

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