Theory Behind the ABC (Pareto) Inventory Analysis

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A Pareto Analysis (also called the 80/20 rule or ABC analysis) is one method of classifying activities, events or items according to their relative importance. It is often used in stock management where it is used to group stock items into classifications based on the total annual expenditure for, or total stockholding cost of, each item. Companies can concentrate a more detailed attention on high value/important items. The Pareto Analysis is employed to decide upon the priorities of each classification.

Vilfredo Pareto, an Italian economist, wrote in 1907 the Pareto Law, which states that about 80 percent of Italy’s wealth was in fact held by about 20 percent of its population. This 80/20 rule is as true for inventory as it is for mostly every concept relating to value. In terms of stock value and sales value, 80 percent of the sales will be represented by 20 percent of the items in stock. Hence, an analysis of stock was derived based upon this law and the analysis is known as an ABC Analysis of Inventory.

Stock is first categorized into the three groups, A, B and C, which encourages a more efficient management of these categories of products. Type A are high rotation items that represent the most popular items, while Type B represent the next most active items. Type C items are, lastly, the slowest movers. In terms of percentages based on ABC Analysis: A items will represent about 12% of the total inventory and roughly 75% of the sales; B items will represent 25% of the total inventory; C items will represent the last 63%. It remains as a matter of strategy that a critically focused control on all your A-type items is vital, since these will account for a large majority of sales and are thus a very manageable percentage.

Higher cycle counts should be performed on these items since they account for the most movement. Other strategies such as holding lower quantities and placing more frequent orders can also reduce not only the amount of capital invested in inventory, but also can reduce the amount of risk involved in holding the asset. It should be noted that this should be done only if you have a very clear customer service level number analyzed. A slipshod execution of a high rotation strategy will likely lead to bad service levels and thus will negatively impact the business.

While the ABC Analysis remains only one method that can be employed by companies, its timeless reflection of the boldest practices within an existing sales process.

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