The items in your inventory are not all the same. As a result, it would be inefficient to treat them the same. It would be expensive and time-consuming, for example, to apply the same strict inventory control procedures to a 3-cent part as to a $3,000 component. "ABC" inventory analysis can help you manage inventory more efficiently, but it's not without its potential pitfalls.

Understanding the ABC Analysis Process

In the ABC method of analysis, you place all of the items in your inventory into one of three categories: A, B and C.

Category A includes critical items – those with the highest value to your company. They tend to be more expensive and have higher margins.

Category C items are the least critical. They tend to be cheaper, low-margin and "nuts and bolts" items.

Category B items are those in the middle.

Boosting Efficiency in Inventory Management

The point of ABC analysis, and the prime advantage of ABC analysis, is efficiency – it allows you to put tight inventory controls only on those items that really need them.

Items in Category A are carefully monitored and handled to prevent theft, damage or waste. Usage and demand are closely tracked so that the company orders enough of these items to meet its day-to-day needs without getting stuck with excess inventory that might go obsolete.

At the other end of the spectrum, Category C items get minimal controls. The company may order large quantities on a regular schedule, review usage maybe once a year and not even bother to track individual pieces.

The Category B items in the middle get standard controls: periodic (but not constant) reviews and occasional usage forecasting.

Identifying Critical Items

The heavy lifting in ABC analysis really comes at the start, when you sort the items into the three categories. This part of the process forces you to take a hard look at your inventory and operations and then identify where your money really comes from, which is an additional benefit of the system.

ABC analysis rests on the Pareto principle, a rule of thumb in economics that holds that about 80 percent of the "output" in any situation comes from about 20 percent of the "input." For inventory management, the numbers may not be precisely 80-20, but the same idea applies.

Category A might make up, say, 5 percent of all items in inventory but represent 75 percent of your inventory's value to your company. Category B might be 20 percent of items and 10 percent of value, and Category C might be 75 percent of items but only 15 percent of value.

Undersupply and Oversupply

One of the disadvantages of ABC analysis is that it's based on dollar values rather on the number of items that cycle through inventory, so there is a risk of running out of low-value, but nevertheless essential, Category B or C items. A small manufacturer might keep close track of the high-value Category A components going into its products. But if it runs out of Category C screws because those screws are so cheap that no one was paying attention to them, production will halt. The opposite can happen, too – excess Category B or C items may pile up in inventory if they are regularly reordered without a review.

Risk of Loss

Just because B and C items aren't as valuable as A items, that doesn't mean they have no value. If the ABC method leads a company to pay too little attention to its inventory of these lower-value items, the risk of loss rises. One of the limitations of ABC analysis is that excess stocks are always in danger of damage or obsolescence, and large amounts of mostly unmonitored and uncounted merchandise are a ripe target for theft.