How Does ABC Analysis Help with Strategy Optimization?

All products and services the company sells make a different contribution to total profit. If we understand which one increases the profit most, it will be possible to optimize the product range and, as a result, improve financial performance.

ABC analysis is a variant of the classical Pareto principle:

"Only 20% of the effort yields 80% of the result".

While talking about products we can say: "Only 20% of goods bring 80% of the profits". ABC-analysis is aimed at identifying this 20%.

The algorithm of analysis is simple — determine what we want to analyze and by which parameter and we are ready to go!

ABC analysis is a universal tool that helps explore the impact of any resources on the growth of business efficiency. You could consider, for example:

• products — to understand which bring in the most money;
• departments — to estimate their contribution to the growth of business value;
• clients — to build the right kind of relationship.

ABC analysis is mostly used for product analysis.

Determine the main goal of the analysis and then choose the indicator. Want to increase the company’s profitability? Take a look at the profit from sales of each product. Want to increase sales? Pay attention to revenue from sales. ABC analysis helps to understand what to do in your particular situation.

You can prepare your data manually or use an automatization tool. For example, FinPlan can help you get a sales report for each product both by profit and revenue.

One more note — it’s all about monetary indicators. Obviously, we can’t compare money to items.

Now let’s get down to business!

Create a new table. The first column has the item name, the second one is about sales volume or profit for the specific period.

• Arrange the second column in descending order.
• Add the third column with the share of profit of each product. Don’t forget to recheck: the sum of all the values in this column equals 100.
• Create the 4th column. It’s accrued in total. For example, if our first product — pens — has a share of 15% in the third column, we write 15%. If the second product — pencils — have 10%, we write 10%+15%=25% in the 4th column, etc. Let’s check ourselves: the last product also has to have a number of 100% next to it.
• If the accrued total is less than 80%, the product goes to group A. Products in a range of 80 to 95% are sent to group B. All the rest is obviously a C.

Companies with a wide range of products usually have about 20% of goods in group A, 30% in group B, and about 50% in group C. And those 50% bring in less than 5% of the profits!

The next part is the most interesting. Let’s figure out what’s hiding behind the letters.

Products from this group deserve particular attention. They bring in the most money and their sales decrease would hit the company hard. While developing your strategy, make a bet on them:

• control quality (to avoid complaints from clients and income decrease);
• maintain sufficient storage on hand;
• actively promote (investments in their advertisement would pay for themselves well)

Products from group B are also important. They bring in regular income. If the revenue formed by group A decreases they can keep the company afloat. However, it’s not worth spending too much money on their procurement or planning a large-scale investment budget. Investments to maintain the current quantities would be good enough.

It’s not all that easy with group C. Numbers tell us that these products are not profitable and should be discontinued. But common sense says that it’s better not to take decisive action without further analysis. This group often consists of new products. They are prospective but haven’t had time to demonstrate good sales figures yet. In this case, it’s better to wait and conduct the analysis one more time.

By the way, it needs to be repeated periodically anyway. The best way to do it is on a monthly or quarterly basis. If you do it more often, random fluctuations can significantly distort the picture.

ABC analysis is good since it’s:

Simple. If you know how to conduct it, you can easily do it on your own and make conclusions. Even if you are using Excel only.

Reliable. The algorithm is pretty straightforward — almost no chance to make a mistake.

Universally applicable. You can estimate ground stocks, contact portfolios, and even your employees. The case is the same) 20% of the resources bring in 80% of the result.

Since it’s a simplified tool, it doesn’t consider everything:

Sales frequency. Imagine a situation when a company sold a $1000000 engine once a year and 3 $1000 auto filters every day. ABC-analysis would show that those products made the same contribution to the profits. However, it doesn’t mean that you have to always have expensive engines in place. Maybe a good idea would be to have them tailor-made. You can answer this question but conducting additional XYZ-analysis.

Distress commodities. You can figure them out with one modification — ABCD analysis.

Reasons for getting into this or that group. One of the products could accidentally get into group C because of seasonality or force majeure. A way to make ABC analysis more accurate is to learn these reasons to avoid getting rid of perspective products.

Despite all the limitations, ABC analysis is a solid base for the optimization of your resources. No matter if the resource in question is product portfolio, clients, or storage. It’s a useful tool showing significant products that improve financial indicators and those which drag you down.