Accounting terms

Dictionary of all accounting terms

What is ABC Analysis?

ABC analysis is a type of inventory categorization method in which inventory is divided into three categories, A, B, and C, in descending value. A has the highest value items, B is lower value than A, and C has the lowest value.

Inventory management and optimization in general is critical for business to help keep their costs under control. ABC analysis works towards this goal by letting management focus most of their attention on the few highest value goods (the A-items) and not on the many low value, trivial goods (the C-items).

ABC Analysis Rules

ABC analysis may be seen to share similar ideas as the Pareto principle, which states that 80% of overall consumption value comes from only 20% of items. Plainly, it means that 20% of your products will bring in 80% of your revenues.

ABC analysis works by breaking it down in the following ways:

  • A-items: 20% of all goods contribute to 70-80% of the annual consumption value of the items
  • B-items: 30% of all goods contribute to 15-25% of the annual  consumption value of the items
  • C-items: 50% of all goods contribute only 5% of the annual consumption value of the items

In order to calculate the annual consumption value of any item or items:

Annual consumption value = annual demand x item cost per unit

That way, the manager can determine which goods bring in the most value and separate those from the numerous goods that provide little profit.

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