ABC analysis: a method for business planning

It is important for man­age­ment to know which products, customers or purchased parts con­tribute most to the company's success. ABC analysis provides a solid as­sess­ment for this purpose and il­lus­trates how important in­di­vid­ual items are for the company. For example, this method enables you to determine which customers con­tribute the most to your total revenue or which purchased parts incur the highest pro­duc­tion costs. This in­for­ma­tion can then serve as a basis for further business planning.

ABC analysis is based on the Pareto Principle which uses the 80/20 rule. When applied to the business sector, this may mean that 20% of customers generate 80% of the revenue. However, it can also mean that 20% of goods take up 80% of the storage space. The ABC method helps to determine which goods, services and customers are more prof­itable and resource efficient and which are un­eco­nom­i­cal and cost intensive.

You can then use the in­for­ma­tion gleaned from analyzing the factors’ costs and benefits to provide a foun­da­tion on which to base business decisions con­cern­ing areas such as customer service, sales and marketing. For example, this can help to identify which customers should be offered special deals given their im­por­tance, which goods should only be purchased when needed due to their high storage costs, which products might benefit from a targeted marketing campaign and which tasks should be pri­or­i­tized if the company gets into a tight spot again.

ABC analysis is therefore an important tool for assessing the current situation in a company and helps those in charge adopt ap­pro­pri­ate measures to increase revenue.

The following example clearly il­lus­trates how to implement ABC analysis in a real-life situation.

Our inital question is: “How can you minimize the pro­cure­ment costs for the man­u­fac­tur­ing of a specific product?” One possible solution would be to purchase cost-intensive resources more sparingly and to process them more ef­fi­cient­ly.

The first step is to use the ABC method to determine which stock materials incur the highest costs.

In this example, you can clearly see that resource 1 and 3 account for the largest share of the pro­cure­ment costs at around 71%, while 2 and 6 are somewhere in the middle at around 25% and 4 and 5 incur the lowest pro­cure­ment costs at only 4% despite their high quan­ti­ties.

This dis­tri­b­u­tion resembles the classic situation you would find in a textbook in which the in­di­vid­ual groups are separated into category A with 80%, category B with 15% and category C with 5%. However, these values are only intended to be used as a rough guide. Each company can define their own limits for the in­di­vid­ual groups based on their needs and even introduce ad­di­tion­al cat­e­gories (D, E, etc.). All that matters is that the in­di­vid­ual items’ per­cent­age shares of the total value differ sig­nif­i­cant­ly so that you can define a clear limit. Otherwise, an ABC analysis will not be able to produce any mean­ing­ful results.

Once you have the data and have assigned the resources into category A, B or C, you can then deduce how to save money in the future. Since resources in category A account for the largest share of pro­cure­ment costs, they should be purchased sparingly and only in small quan­ti­ties. Depending on the specific resource in category A and how easy or difficult it is to procure it, it may even make sense to only purchase it as needed.

Meanwhile, resources in category C are needed in large quan­ti­ties and are cheap to procure. They only account for around 4% of pro­cure­ment costs. Therefore, they can be purchased and stored for the long term as long as there is suf­fi­cient storage space available and storing them over the long term does not incur any ad­di­tion­al costs. You can determine whether this is the case through an ad­di­tion­al ABC analysis which focuses only on storage costs.

As demon­strat­ed in the example above, ABC analysis is great for breaking complex processes down to their es­sen­tials and pre­sent­ing them in an easy-to-un­der­stand way. All companies have the key figures required for this analysis since they are needed for con­trol­ling and ac­count­ing anyway. This means that the prepa­ra­tion time needed is man­age­able and that the analysis can be easily conducted at any time. Another one of this method’s strengths is that it can be applied to a wide variety of business areas and can thus provide valuable in­for­ma­tion for future strategic business decisions.

Nev­er­the­less, this method does have its dis­ad­van­tages. For example, in some cases the use of three cat­e­gories is too general. In addition, it does not make sense to use this method if the different items’ per­cent­age shares of the total value barely differ from one another, since this makes cat­e­go­riza­tion very difficult or even im­pos­si­ble. In this kind of situation, other analysis methods would be much more useful. Another dis­ad­van­tage is that ABC analysis usually only compares a single factor within the cat­e­gories. It also only takes quan­ti­ta­tive factors into account. The ABC method does not examine how qual­i­ta­tive changes can affect revenue.

With just a little effort, however, you can modify ABC analysis to adapt it to the specific con­di­tions within your company. For example, you could add ad­di­tion­al cat­e­gories or combine several factors together be­fore­hand to create a new key figure to compare if needed.