Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.
In this lesson, we will explore ABC cost and inventory analysis. We will define it, look at some examples, and explain why a company may use this type of system. The lesson will conclude with a summary and quiz.
Introduction to ABC Analysis
Meet Tina! Tina is the manager for So Soft Sweaters. Part of her job is taking care of all of the inventory the store has. She orders it, stores it, organizes it, and keeps a total of what is in stock and what has low inventory. Basically, anything that is inventory related, Tina takes care of it.
While she has always been good at her job, lately she has become a bit overwhelmed. You see, the store has recently started to carry many more styles of sweaters, which has made Tina's job a bit more challenging. Instead of having to only organize and keep track of 50 types of sweaters, she now has 185 types. Tina realizes that she needs a better system of organizing and analyzing the inventory the store has. After much research, she decides to utilize the ABC inventory analysis.
The great thing about this type of inventory analysis, is that the name helps explain and define it. The ABC stands for activity based costing, and ABC inventory analysis is a way for a company to categorize inventory based on importance. It is also a way for a company to understand overhead and direct expenses based on the most important activities of the business and then categorize them based on that importance. Finally, the ABC inventory analysis allows a company to better visualize those areas within the company that generate the most profit.
Examples of ABC Inventory Analysis Use
Because the ABC inventory analysis can be used several ways, let's look at a few examples to show how this type of system can be beneficial for a company.
If we take Tina and her sweater store from earlier, we know that she has many types of sweaters to inventory but seems to need a better system to organize and keep track of everything. Utilizing the ABC inventory analysis, Tina might organize her data the following way:
Category A- The sweaters that fall within this category are the most important sweaters in the company. For instance, they may be the sweaters that are the highest in demand and the hottest trend for the season.
Category B- These sweaters are important to the company but do not possess as high of a priority. Perhaps there is a smaller market for these sweaters, and therefore, they do not sell as well or as quickly as those in category A. An example may be Christmas sweaters. While they are important around the Christmas holiday, after Christmas, they do not sell as well as those sweaters that are in category A.
Category C- This is the last category of inventory. Those sweaters that do not fall within category A or B, fall within category C. They are the least important of all sweaters and do not have as high of a value to the company. These do not have a high priority and probably do not sell very well year-round. Some sweaters that may fall within this category are those sweaters that may be an odd size, or color.
Another way that Tina can categorize her inventory using the ABC method, is by revenue. For example:
Category A sweaters bring in the most revenue for the company. They account for 80% of all revenue. These sweaters sell fast and easy and are in high demand.
Category B sweaters account for 15% of revenue. These sell better than sweaters in category C but do not sell as well as those in category A. They only bring in a small portion of sales for the company.
Category C sweaters only account for 5% of all revenue. They are hard sellers in the store and may only attract a very small clientele. They are not in high demand and have the lowest of priority and the lowest amount of sales.
Benefits of ABC Inventory Analysis
While we know how a company may break up their inventory using the ABC inventory analysis, we still have yet to answer why a company might utilize this type of method. By breaking up inventory into importance, a company is able to more closely monitor higher-priority inventory. By knowing which inventory that consumers request most frequently, a company is able to keep those products in stock.
Category A items are the most highly demanded products and are directly related to the success of the company. For instance, if a product is in high demand but out of stock, customers will not be happy and may do business with another company. If, however, a company uses the ABC inventory analysis, they will better understand which products are in high demand and therefore can place those products in category A, where they receive the highest priority and stock levels coordinate with demand.
With the ABC standing for activity based costing, ABC inventory analysis is a way for a company to categorize inventory based on importance. Those items that are the most important fall under category A. Those that are the least important fall under category C. And those products that are not as important as category A but have a higher priority than those items in category C, are placed in category B. A company can use the ABC method to better understand the demand of their products, as well as those that bring in the most revenue.
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