What is ABC Analysis? How does ABC analysis work?

ABC Analysis

Last Updated on June 30, 2024 by Team Experts

Management in business is a tough job. Whether you’re handling people (employees and customers) or product/service inventory, it requires an attention to detail that keeps the company’s bottom line in view and doesn’t waste company resources.

This is where ABC analysis comes in. This management model is an offshoot of the Pareto principle, also known as the 80/20 rule. This rule says that 20 percent of efforts will be responsible for 80 percent of the results. In inventory management, this could be rephrased to state that 20 percent of your products will be necessary for 80 percent of sales. The same statement can apply to clients/customers, as well.

What ABC analysis does is that it helps to categorize your customers or products into different classes of business impact. This will help you to distribute your time and resources proportionately across these categories, such that each of them gets only the resources they need to yield optimal results and nothing more.

ABC analysis can be performed across many industries and sectors, such as e-commerce, shipping and marine endeavors, SaaS companies, manufacturing, healthcare, etc.

How does ABC analysis work?

The ABC analysis model instructs managers to categorize their products, services, customers, or clients into three distinct vertical categories. Essay writing service review company, Online Writers Rating’s Angela Baker, refers to these categories as “the penthouse, the main building, and the basement.”

The first group, Category A, is the most important one of the three. This is the group that consists of your most valuable products or highest-paying customers. The people and products in this category are individually crucial to your business’s success.

If even one of them is absent, it will significantly impact your bottom line. Perhaps, it makes sense then that this is typically the smallest group by volume; it is exclusively reserved for the biggest money makers—whether product or client.

Consider Apex, a fictitious phone manufacturing company with a long product lineup, with just about six models being high-end phones. These high-end phones are priced at an average of $1499 and sell 6.5 million units annually. Meanwhile, Apex’s robust lineup of mid-range and budget phones ship 20 million units at an average price of $325 per unit. The high-end phones would have brought in $9.74 billion, while the other categories would have recorded $6.5 billion. Even though Apex’s premium models sold significantly fewer units (only 24.5 percent), they account for 60 percent of revenue. This means that the six high-end models are Category A products.

Category B is where all the products and customers that are not so high up the food chain to be considered Category A are lumped into. But make no mistake; this category is responsible for a healthy amount of your revenue; they are seen as the transition or “promise category.” This is because they have the potential to become Category A with some development and nurturing.

Category C can be termed the “strength in numbers” category. This is because the people or items in this group can only bring something to the table as a collective; individually, their value is considered dispensable. This is typically the category with the majority of customers and products. Smart managers know not to waste company resources here. It is the ideal category to automate sales to minimize overhead costs.

How to implement ABC analysis in segmenting your customers

Just as some people fly first class, others fly business class, and the rest fly economy, you need to categorize your customers to know which ones bring the most value to the company and which ones don’t. Customer segmentation helps to optimize resource allocation and bolster revenue and ROI significantly.

To apply ABC analysis in customer categorization, you’ll need data for individual customers concerning revenue potential, sales revenue, support costs, and contribution margin.

Use each of these metrics to create a chart with your customers’ data, making four charts in total, one for each metric. Find out where each customer ranks for each metric and put them in their proper place on the chart.

Next, make a comparison of the contribution margin and sales revenue charts. From these charts, the customers ranked highest in sales revenue and contribution margin are Category A customers. This means that they bring in the majority of the company’s revenue and contribute the most to money seen as net profit and used for offsetting fixed costs. These customers are invaluable to the company.

Go back to the charts again. The next crop of loyal customers who spend reasonable amounts of money regularly is placed in Category B. In the same vein, they contribute well to the contribution margin and revenue, but not as much as those in Category A—at least not yet.

All the customers leftover from this analysis belong in Category C. These ones purchase every once in a while or make many tiny value purchases. This category of people usually shows no potential of moving up into Category B.

This is why depending on sales figures can be misleading. With sales figures, you’d mistake the active customer making frequent tiny purchases as a valuable customer. In truth, he isn’t adding much to the company’s profit and sales.

The ABC analysis identifies the valuable customers, measures their value, and determines if they could be of more value or not. The analysis also gives insight on how to allocate resources for maximum revenue. You could even discover that you’re committing too many resources to your Category A customers.

How to implement ABC analysis in inventory management

In shipping terms, or I should say, the shipping industry, ABC analysis is one of the most powerful marine definitions. It is instrumental when it comes to inventory control. Imagine a vessel already out to sea discovers it doesn’t have the needed critical stock items on board to keep it functioning optimally. A proper ABC analysis could prevent such a scenario that can cause anywhere from a minor maintenance issue to an all-out catastrophe.

However, ABC analysis extends itself beyond the shipping world’s charter glossary and can be applied in any industry that deals with inventory.

Items in your inventory do not all cost the same. Naturally, with this analysis, the items with the most impact on your inventory cost go to the top of the pile, and the rest spread themselves across the other two categories in decreasing order of impact.

It is not uncommon for ABC analysis to show you an inventory situation where:

  • Category A products/sales make up 20 percent of total inventory/product movement and 70 percent of inventory cost or product revenue
  • Category B products/sales make up 30 percent of total inventory/product movement and 25 percent of inventory cost or product revenue
  • Category C products/sales make up 50 percent of total inventory/product movement and 5 percent of inventory cost or product revenue

Final Words

Like with customer segmentation, the ranges stipulated for each inventory category are company-specific. Since companies have different customer and inventory situations, they have to define the category thresholds themselves. This is the only way that companies can glean reliable and actionable insight from performing ABC analysis.

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She has over 7 years of experience writing about technology, education, digital marketing, general and business. Her experience in the tech industry (fieldengineer, wowtechub, techsprohub, techinfobeez) has taught her how to write engaging, informative content that makes complex issues accessible to a wide audience. Follow her on Linkedin

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