How ABC Analysis Allows You to Increase the Margin and Make Profit
By Thomas Bennett Financial expert at Priceva
Published on November 2, 2023
If you're involved in e-commerce, you're likely well-aware that managing product inventory can be a challenging task. One of the simplest yet time-tested tools to facilitate this process efficiently is ABC analysis. In this article, we'll delve into everything you need to know about this methodology.
Defining ABC Analysis and Its Purpose
ABC analysis stands as a stellar technique to evaluate your product inventory. Using this method, businesses can discern the contribution of goods or services to the company's turnover and profits, segmenting them into three distinct categories. This analysis fundamentally hinges on the universal Pareto principle.
To put it succinctly for retailers, the essence of the principle can be interpreted as: 20% of products generate 80% of the revenue, while the remaining 80% of products account for the residual 20%. However, in ABC analysis, products are typically divided into three segments:
Segment A: The most valuable and in-demand products. The overall success of the company largely depends on their sales performance. Even a slight dip in sales of this segment can significantly impact the company's net profit. Products in the "A" category must always be readily available in the required quantities.
Segment B: Products of moderate demand and profitability.
Segment C: Products with the lowest metrics. Such items, often referred to as SKUs, are either eliminated from the inventory or minimized. This segment may also include newly launched products.
To put it succinctly for retailers, the essence of the principle can be interpreted as: 20% of products generate 80% of the revenue, while the remaining 80% of products account for the residual 20%. However, in ABC analysis, products are typically divided into three segments:
Segment A: The most valuable and in-demand products. The overall success of the company largely depends on their sales performance. Even a slight dip in sales of this segment can significantly impact the company's net profit. Products in the "A" category must always be readily available in the required quantities.
Segment B: Products of moderate demand and profitability.
Segment C: Products with the lowest metrics. Such items, often referred to as SKUs, are either eliminated from the inventory or minimized. This segment may also include newly launched products.
Despite its simplicity, this method proves highly informative and enables effective inventory management.
The Significance of ABC Analysis
• ABC analysis empowers companies to rank products, identifying those with the most substantial impact on profitability and sales volume. With this technique, the contribution of each category and individual product to the company's overall performance becomes transparent.
• Regularly conducted ABC analysis aids companies in timely adjustments of their marketing strategy and pricing policy.
• Employing ABC analysis is indispensable when dealing with a vast inventory matrix, especially when one sales or pricing specialist handles hundreds, if not thousands, of items. This analytical technique enables a swift assessment of a vast volume of data, highlighting which specific categories necessitate special attention.
• ABC analysis assists in regulating warehouse stock, reducing non-moving inventory, and ensuring the availability of sought-after products.
• The ABC method reveals inefficient resource allocations, enabling timely measures aimed at risk minimization, cost optimization, and re-evaluation of priorities.
Overall, ABC analysis stands as a potent tool, poised to elevate the efficiency of any online store.
• Regularly conducted ABC analysis aids companies in timely adjustments of their marketing strategy and pricing policy.
• Employing ABC analysis is indispensable when dealing with a vast inventory matrix, especially when one sales or pricing specialist handles hundreds, if not thousands, of items. This analytical technique enables a swift assessment of a vast volume of data, highlighting which specific categories necessitate special attention.
• ABC analysis assists in regulating warehouse stock, reducing non-moving inventory, and ensuring the availability of sought-after products.
• The ABC method reveals inefficient resource allocations, enabling timely measures aimed at risk minimization, cost optimization, and re-evaluation of priorities.
Overall, ABC analysis stands as a potent tool, poised to elevate the efficiency of any online store.
How to Conduct ABC Analysis
Conditions for applying ABC analysis
Conditions for applying ABC analysis
• Analyze objects that have a numerical characteristic.
• The list for analysis should consist of homogeneous items (you can't compare refrigerators with extension cords as these products occupy significantly different price ranges). If you aim to analyze the entire inventory, it should be divided into product categories.
• Choose maximally objective values (ranking parameters by monthly revenue is more accurate than by daily revenue).
• The list for analysis should consist of homogeneous items (you can't compare refrigerators with extension cords as these products occupy significantly different price ranges). If you aim to analyze the entire inventory, it should be divided into product categories.
• Choose maximally objective values (ranking parameters by monthly revenue is more accurate than by daily revenue).
Steps for Conducting ABC Analysis
Steps for Conducting ABC Analysis
• Choose a criterion by which all products will be sorted: by turnover, revenue, profitability, etc.
• Next, arrange the products, for instance, when analyzing based on profit, from the most profitable to the least.
• The subsequent step is to determine the share of each product. ABC analysis formulas in "Excel" can be handy for this purpose.
• Next, arrange the products, for instance, when analyzing based on profit, from the most profitable to the least.
• The subsequent step is to determine the share of each product. ABC analysis formulas in "Excel" can be handy for this purpose.
• Then, compute the cumulative total for each item on the list. To illustrate, the cumulative share of product D6 = C6+D5, and so on.
Following that, demarcate the boundary at around 80% (in this example, it's 82%) for the "A" category of products, 80–95% for the "B" category, and 95–100% for the "C" category.
As an example, the result of grouping products into three categories is showcased. This illustrates that products 1-4 account for 83% of all sales; products 5-7 contribute to 13% of sales; while products 8-11 bring in just 6% of total sales revenue.
As an example, the result of grouping products into three categories is showcased. This illustrates that products 1-4 account for 83% of all sales; products 5-7 contribute to 13% of sales; while products 8-11 bring in just 6% of total sales revenue.
The generalized 80/20 Pareto distribution doesn't always match reality. In practice, when determining the actual percentage breakdown, other distributions might emerge based on the specifics of the product category, store, or retail chain.
Here are possible percentage breakdowns for categories A, B, and C:
80-15-5,
70-20-10,
50-30-20,
and even 40-40-20.
You can gradually expand the ABC analysis. Initially, you can analyze any product group based on a single criterion that's most important to you. For instance, you can first evaluate products ranked by revenue, and in the second stage, by profitability. In the latter case, instead of three groups, you'd get nine: AA, AB, AC, BA, BB, BC, CA, CB, CC.
For a comprehensive understanding of inventory prioritization, it's ideal to analyze it simultaneously based on three criteria: revenue, profitability, and sales volume.
Profitability is the portion of the margin as a percentage of the sales figure. This metric shows what percentage of every dollar you retain from a sale.
Formula: Margin = Sales − Cost |Profitability = Margin / Sales * 100%
Measurement: In dollars | In percentages
Example: If a store buys a product for 5,000 dollars and sells it for 8,000 dollars, then this product generates a 3,000 dollars margin, and its profitability is 37.5%.
Profitability: 3,000 / 8,000 * 100% = 37.5%
By analyzing these three criteria, you'll obtain a matrix of 27 categories. The top-performing product will fall into the AAA category, while the least performing will be labeled CCC. A product with the code ABV will emerge as a sales leader but will be average in terms of margin and profitability, etc.
The percentage of products you decide to label as group A, B, or C is up to you, with possible variations listed above.
Here are possible percentage breakdowns for categories A, B, and C:
80-15-5,
70-20-10,
50-30-20,
and even 40-40-20.
You can gradually expand the ABC analysis. Initially, you can analyze any product group based on a single criterion that's most important to you. For instance, you can first evaluate products ranked by revenue, and in the second stage, by profitability. In the latter case, instead of three groups, you'd get nine: AA, AB, AC, BA, BB, BC, CA, CB, CC.
For a comprehensive understanding of inventory prioritization, it's ideal to analyze it simultaneously based on three criteria: revenue, profitability, and sales volume.
Profitability is the portion of the margin as a percentage of the sales figure. This metric shows what percentage of every dollar you retain from a sale.
Formula: Margin = Sales − Cost |Profitability = Margin / Sales * 100%
Measurement: In dollars | In percentages
Example: If a store buys a product for 5,000 dollars and sells it for 8,000 dollars, then this product generates a 3,000 dollars margin, and its profitability is 37.5%.
Profitability: 3,000 / 8,000 * 100% = 37.5%
By analyzing these three criteria, you'll obtain a matrix of 27 categories. The top-performing product will fall into the AAA category, while the least performing will be labeled CCC. A product with the code ABV will emerge as a sales leader but will be average in terms of margin and profitability, etc.
The percentage of products you decide to label as group A, B, or C is up to you, with possible variations listed above.
By placing products in this matrix, you'll produce a volumetric ABC analysis report, where all store items will be assigned appropriate rankings. From there, all that remains is to correctly interpret the obtained results.
Price Adjustment Based on ABC Analysis
Let's delve into how we can adjust pricing strategies based on the insights garnered from ABC analysis. The primary goal is to achieve the highest possible price for a product without experiencing a drop in sales.
Here are some foundational suggestions:
1. Maintain Current Pricing: This applies to products labeled AAA, AAB, AAC, ABA, ABB, ABC, ACA, ACB, ACC. It's not recommended to raise prices on products that are top sellers (Group A). Due to their high demand, consumers will quickly notice any price surge and might opt for a more affordable alternative or turn to your competitors. In either case, sales would likely decline.
2. Reduce Prices: Specifically for products CAA, CBA, CCA. Products that are in Group A for profitability but in Group C for sales might benefit from a price reduction, either as part of a promotional campaign or as a permanent change. These products yield a significant margin but aren't selling as well as they could. A price cut might stimulate sales, ensuring you remain profitable.
3. Increase Prices: For products labeled BAB, BAC, BBA, BBB, BBC, BCB, BCC, CAB, CAC, CBB, CBC, CCB, CCC. Products with B or C ratings in sales combined with B or C in profitability can likely sustain a price increase of 1-15%, depending on the margin. These items don't fly off the shelves as fast as Group A products, so most consumers won't notice a moderate price hike. This strategy can bolster both profitability and margin.
Strategies to Enhance Margins by 10% and Profits by Up to 5x in Six Months, Based on ABC Analysis
1. Monthly Price Increases: Every month, consider raising prices by 5-10% for SKUs in the B/C categories in terms of profitability and sales volume. Customers in these segments are less likely to notice small price increments, ensuring an increase in your margin and overall profit.
2. Monthly Product Assessment: Regularly review products that fall into the C category in terms of margin:
• Phasing out the CCC combination from your inventory.
• For the remainder, seek high-margin alternatives to ensure no gaps in product availability.
If the C category isn't addressed effectively, unsold stock will clutter the storage, and low-margin products might erode your profits.
3. Monthly Motivation for the Sales Team: Focus on pushing the top 10/20 products of the month, which come from the A category in terms of margin percentage and B/C in volume. Offer incentives to sales personnel who meet these goals, leading not just to increased motivation but also a spike in the company's marginal revenue.
4. Discounting Strategy: Consider giving discounts on products in the A category for margin percentage and in the C category for sales volume. However, do this only after ensuring that the increase in sales will offset the potential revenue loss from reduced prices. A bonus to this approach is that customers, attracted by the discounted price, might try slower-moving items. Some of these customers might then continue to purchase these products at the regular price.
5. Advertising Budget Allocation: Prioritize promoting AAA category products and those where the margin falls in the A category. Focus on stimulating sales of items that are guaranteed to provide a substantial return.
6. Inventory Ordering according to Non-Reducible Stock: Order products based on a set minimum inventory level, designed in accordance with a 2.0 coefficient for A category, 1.5 for B, and 1.2 for C. This ensures protection against potential logistic hitches, and prevents stock from sitting idly in the warehouse for prolonged periods.
*Inventory* is the sum of products in the warehouse and on the sales floor available for purchase.
*Non-reducible stock* refers to the minimum volume of products that must be maintained in the warehouse for smooth operations. When stocks approach this threshold, it's essential to place orders for the next batch. Otherwise, you risk running out, missing out on profits, and alienating loyal customers.
7. Monthly Supplier Market Monitoring: Regularly screen the supplier market for new and intriguing products at competitive prices. Negotiate for discounts. Conduct customer surveys regarding product assortment and frequently compare the prices and assortments of competitors.
Here are some foundational suggestions:
1. Maintain Current Pricing: This applies to products labeled AAA, AAB, AAC, ABA, ABB, ABC, ACA, ACB, ACC. It's not recommended to raise prices on products that are top sellers (Group A). Due to their high demand, consumers will quickly notice any price surge and might opt for a more affordable alternative or turn to your competitors. In either case, sales would likely decline.
2. Reduce Prices: Specifically for products CAA, CBA, CCA. Products that are in Group A for profitability but in Group C for sales might benefit from a price reduction, either as part of a promotional campaign or as a permanent change. These products yield a significant margin but aren't selling as well as they could. A price cut might stimulate sales, ensuring you remain profitable.
3. Increase Prices: For products labeled BAB, BAC, BBA, BBB, BBC, BCB, BCC, CAB, CAC, CBB, CBC, CCB, CCC. Products with B or C ratings in sales combined with B or C in profitability can likely sustain a price increase of 1-15%, depending on the margin. These items don't fly off the shelves as fast as Group A products, so most consumers won't notice a moderate price hike. This strategy can bolster both profitability and margin.
Strategies to Enhance Margins by 10% and Profits by Up to 5x in Six Months, Based on ABC Analysis
1. Monthly Price Increases: Every month, consider raising prices by 5-10% for SKUs in the B/C categories in terms of profitability and sales volume. Customers in these segments are less likely to notice small price increments, ensuring an increase in your margin and overall profit.
2. Monthly Product Assessment: Regularly review products that fall into the C category in terms of margin:
• Phasing out the CCC combination from your inventory.
• For the remainder, seek high-margin alternatives to ensure no gaps in product availability.
If the C category isn't addressed effectively, unsold stock will clutter the storage, and low-margin products might erode your profits.
3. Monthly Motivation for the Sales Team: Focus on pushing the top 10/20 products of the month, which come from the A category in terms of margin percentage and B/C in volume. Offer incentives to sales personnel who meet these goals, leading not just to increased motivation but also a spike in the company's marginal revenue.
4. Discounting Strategy: Consider giving discounts on products in the A category for margin percentage and in the C category for sales volume. However, do this only after ensuring that the increase in sales will offset the potential revenue loss from reduced prices. A bonus to this approach is that customers, attracted by the discounted price, might try slower-moving items. Some of these customers might then continue to purchase these products at the regular price.
5. Advertising Budget Allocation: Prioritize promoting AAA category products and those where the margin falls in the A category. Focus on stimulating sales of items that are guaranteed to provide a substantial return.
6. Inventory Ordering according to Non-Reducible Stock: Order products based on a set minimum inventory level, designed in accordance with a 2.0 coefficient for A category, 1.5 for B, and 1.2 for C. This ensures protection against potential logistic hitches, and prevents stock from sitting idly in the warehouse for prolonged periods.
*Inventory* is the sum of products in the warehouse and on the sales floor available for purchase.
*Non-reducible stock* refers to the minimum volume of products that must be maintained in the warehouse for smooth operations. When stocks approach this threshold, it's essential to place orders for the next batch. Otherwise, you risk running out, missing out on profits, and alienating loyal customers.
7. Monthly Supplier Market Monitoring: Regularly screen the supplier market for new and intriguing products at competitive prices. Negotiate for discounts. Conduct customer surveys regarding product assortment and frequently compare the prices and assortments of competitors.
Summary
Even such a basic and long-established method of inventory analysis, when correctly applied, can yield significant insights.
What you need to do:
1. Categorize all products and accurately conduct ABC analysis for each.
2. Identify 27 ABC combinations for each category, based on total margin, margin percentage, and sales volume.
3. Detail five rules for each of these combinations within each category concerning purchases, advertising, discounts, promotions, and price hikes.
4. In total, you should devise 135 guidelines to implement and review each month.
Yes, this approach requires substantial initial effort, but rest assured, it will pay off handsomely. It will minimize mistakes and provide a clear framework for effective actions across each product group.
What you need to do:
1. Categorize all products and accurately conduct ABC analysis for each.
2. Identify 27 ABC combinations for each category, based on total margin, margin percentage, and sales volume.
3. Detail five rules for each of these combinations within each category concerning purchases, advertising, discounts, promotions, and price hikes.
4. In total, you should devise 135 guidelines to implement and review each month.
Yes, this approach requires substantial initial effort, but rest assured, it will pay off handsomely. It will minimize mistakes and provide a clear framework for effective actions across each product group.
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