Why Apply ABC Analysis in Inventory Management?

9 min read

Inventory management is a significant asset of any successful business. It’s the process of tracking and controlling a company’s purchased, manufactured, and stored inventory. Inventory management helps avoid overstocking, overselling, and other unwanted challenges an unclassified operation system might result in. To avoid any issues, a company should choose an inventory management technique that will contribute to its strategies and the set goals. With respect to this, today’s article will be devoted to the ABC analysis in inventory management (also known as the Always Better Control strategy). 

ABC analysis in inventory management


Brief Definition of ABC Analysis in Inventory Management


Applying Pareto’s principle on a retail company’s inventory value, the ABC analysis is implemented. 

In short, ABC analysis is aimed to sort the existing inventory into three main subcategories: A, B and C. As the reader might have already guessed from the name, A items stand for the products that have the highest demand, i.e., the company’s best-performing inventory. B items stand for the middle-ranged products. Finally, the C items include the company’s worst-sold products. Such inventory is also referred to as dead stock. The benefits coming from the C items are so low that it is essential to track and reorder them to avoid possible inventory losses. For a more detailed explanation of the essence of the ABC analysis, check our previous article (link here). 


Are There Any Shortcomings in ABC Analysis? 


Like any tool, strategy or technique ABC Analysis has several shortcomings that the companies should be aware of before putting the strategy into practice:


Regular control required

Regular calculations and analysis are crucial to ensure that A items continuously include high-priority products. Without proper supervision, a company risks lowering the bar and significantly losing its authority among the consumers.


Low precision

Sometimes it is possible to overvalue frequently purchased but cheap products. In such cases, more expensive luxury goods that are sold less frequently should be treated as A items because they provide higher profits. 


Ignoring GAAP

The ABC Analysis doesn’t follow the Generally Accepted Accounting Principles. Thus, when applying this strategy, a retailing company needs to operate two separate costing systems, using the ABC analysis for internal operations and the other one to correspond to GAAP.


Why Is ABC Analysis Not Enough?


Companies applying ABC analysis in inventory management are often making common mistakes:

  • First mistake: Hoping not to miss any sales, companies put larger-than-necessary inventory coverage on A items.
  • Second mistake: Believing that A items have stable sales, companies put lower-than-necessary inventory coverage. 

In many cases, a solution to this is the development of a standard ABC analysis into an ABC XYZ analysis.


What Is ABC XYZ Analysis?




The purpose of ABC XYZ analysis is to classify the inventory according to volumes and uncertainty risks. Therefore, this is an efficient strategy for inventory optimization and management. 

The uncertainty risks depict the instability in sales. The XYZ analysis, on the contrary, completely ignores consumption values.

Each letter represents a specific product type in XYZ analysis, like ABC. X items are stable and easily predictable products; Y items include less stable but still predictable products; Z items are volatile and unpredictable. According to XYZ analysis, X items need to be replenished automatically, while the Z items should be replenished only on customer orders.

The combination of ABC and XYZ approaches results in the formation of a nine-categories matrix.



The Matrix of Nine Categories


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Inventory, Order & Shipping Management Software


When putting into practice the ABC XYZ analysis, the following inventory division takes place:

AX – large consumption volumes; the most stable products

AY – large consumption volumes; little stability that results in having changeable products

AZ – large consumption volumes; unstable products

BX – medium consumption volumes; stable products

BY – medium consumption volumes; little stability

BZ – medium consumption volumes; unstable products

CX – low consumption volumes; stable products

CY – low consumption volumes; little stability

CZ – low consumption volumes; unstable products


The Main benefits of ABC Inventory System Combined With XYZ Approach


The ABC XYZ analysis helps identify the products at risk to avoid overstocking and overselling. In addition, it helps to implement detailed analysis of the whole inventory and “play it safe” with reliable forecasting. 

ABC XYZ’s approach provides a firm ground for developing and putting into practice stock management policies. Moreover, with the help of this analysis, it is possible to “divide” the customers into conditional segments. This practice makes studying and analyzing the customers’ purchasing and behavioral patterns easier.


How to Calculate ABC XYZ Inventory Analysis?


XYZ Inventory analysis calculations are implemented according to a strictly established formula (just like with any other analysis). Below are the steps to categorize your inventory into X, Y, and Z items:

  1. Identify the products you’d like to analyze;
  2. Find the coefficient of variation for each product (standard deviation/mean) * 100;
  3. Sort the items according to the increase of coefficients;
  4. Set boundaries for each category.


Note: When analyzing inventory with seasonal demand, make sure to use 12 months of data to make the calculations and forecasts more precise. 

Now that you have a clear understanding of your inventory volumes and the possible uncertainty risks, it is helpful to know that each category should be treated uniquely. Using inventory optimization tools will help you automatically identify and classify your products according to the set strategic policies. 


Final Thoughts

ABC analysis helps the retailers and every company dealing with significant inventory volumes to identify and concentrate on the most important items or the critical few their customers need. In combination with the XYZ approach, the method helps keep the costs under control and have a clear understanding of a company’s supply chain system operation. As shown above, getting the first results from this inventory management strategy, the companies get extra time to focus on their consumers’ needs.