How to conduct an ABC analysis of products and understand what brings you the most profit?

Imagine this: you have 500 products in your inventory, but you don't know which ones are truly profitable and which are just taking up space in the warehouse. Every day, managers spend the same amount of time on all items, even though a small number of products generate the lion's share of revenue.

ABC analysis — is a product classification method that helps identify the most important items and optimize their management. It's based on the Pareto principle and allows you to focus on what's truly important to your business.

What is ABC analysis?

ABC analysis is a method for categorizing objects (products, customers, suppliers) according to their importance to the business. The method divides all items into three groups:

• Category A (most important) — 15-20% of goods that generate 70-80% of revenue or profit
• Category B (medium importance) — 30-40% of goods, providing 15-20% of revenue
• Category C (least important) — 40-50% of goods, generating 5-10% of revenue

The core idea of the method is that not all products are equally important to a business. Understanding which items generate the most profit allows one to set the right priorities in managing inventory, purchasing, and logistics.

Pareto method (80/20 principle)

ABC analysis is based on Pareto principle, which is also known as the 80/20 rule. This principle was formulated by the Italian economist Vilfredo Pareto in the late 19th century.

The essence of the principle: 20% of efforts bring 80% of the results, and vice versa - 80% of efforts bring only 20% of the results.

In terms of inventory management, this means:

• About 20% of products generate approximately 80% of revenue
• 80% of products generate only 20% of revenue
• A small group of clients generates the majority of profits
• A small number of suppliers provide the bulk of supplies

By applying the Pareto principle, companies can:

• Focus on the most profitable products
• Optimize warehouse inventory and logistics
• Allocate more resources to work on key positions
• Make informed decisions about product range

How to Conduct an ABC Analysis: A Step-by-Step Guide

Conducting an ABC analysis is a structured process that includes data collection, calculations, and interpretation of results. Let's look at each step in detail.

1. Define Analysis Criterion
   Select the parameter by which you will evaluate products. The most commonly used are:
   • Sales revenue (the most popular criterion)
   • Profit (a more accurate measure of performance)
   • Sales volume in units
   • Product turnover
2. Collect data
   Download data from the accounting system for the selected period (usually 3-12 months):
   • Product name
   • Article number or SKU
   • Revenue or profit for each item
   • Number of units sold
3. Calculate the share of each product
   Calculate the percentage contribution of each item to total revenue using the formula:
   Product Share (%) = (Product Revenue / Total Revenue) x 100%
4. Sort the products
   Arrange all items in descending order of their share of revenue - from the most profitable to the least profitable.
5. Calculate the accumulated share
   Sum up the product shares sequentially, starting with the most profitable one. This will allow you to see the cumulative effect.
   Accumulated share = Sum of shares from the first product to the current one
6. Organize your products into categories
   Divide the products into three groups based on accumulated share:
   • Category A: goods whose accumulated share is 0-80%
   • Category B: goods with an accumulated share of 80-95%
   • Category C: goods with an accumulated share of 95-100%
7. Analyze the results
   Study the resulting distribution and identify patterns:
   • How many products were included in each category?
   • What percentage of revenue does each group generate?
   • Are there any unexpected results?

A practical example with calculations

Let's look at a simplified example of ABC analysis for a small online sporting goods store. Data is taken over the past six months.

Initial data

Example of calculating the share of goods

Analysis of results

How to use the results of ABC analysis

Once you've classified your products, it's important to apply this knowledge effectively in your daily work. Here are practical recommendations for each category:

Working with Category A products

• Inventory control: Ensure these items are always in stock. Product A shortages have a critical impact on revenue.
• Order frequency: Place orders with suppliers more frequently than for other categories to minimize the risk of stock-outs
• Negotiations with suppliers: Negotiate better delivery terms, discounts, and priority service
• Marketing: Allocate more budget to promoting these products - they provide the highest return
• Analytics: Monitor sales and inventory of Category A products daily
• Pricing: Keep a close eye on competitors' prices for these items.

Working with Category B products

• Inventory control: Maintain average inventory levels with periodic checks
• Order frequency: Optimize order size and frequency to reduce logistics costs
• Monitoring: Check your balances 1-2 times a week
• Growth Potential: Analyze whether some B products can be upgraded to Category A through marketing or improved conditions
• Optimization: Consider consolidating supplies to save money

Working with Category C products

• Minimizing inventory: Keep minimum stock or work on order
• Order frequency: Buy rarely and in small quantities
• Assortment revision: Regularly review the advisability of maintaining these positions.
• Alternatives: Consider dropshipping for C products instead of storing them in a warehouse
• Simplification: Minimize the time managers spend working with these products
• Decision to exclude: If a product is not profitable and does not fulfill strategic functions, it can be removed from the assortment

XYZ Analysis: A Complement to ABC

For a deeper understanding of the product range structure, ABC analysis is often supplemented XYZ analysis, which classifies goods according to the stability of demand.

Categories of XYZ Analysis

• Category X: Products with stable, predictable demand (low sales variance). Variation coefficient up to 10%
• Category Y: Products with moderate demand fluctuations (medium variation). Coefficient of variation 10-25%
• Category Z: Products with irregular, unpredictable demand (high variation). The coefficient of variation is over 25%.

Formula for the coefficient of variation

Combined ABC-XYZ analysis

By combining both methods, we obtain 9 product groups (AX, AY, AZ, BX, BY, BZ, CX, CY, CZ), for each of which an individual management strategy can be developed:

Conclusion

ABC analysis is a powerful tool for understanding your business structure and optimizing your product mix. It helps answer key questions:

• Which products generate the most profit?
• Where should the team focus its efforts?
• How to optimize warehouse inventory?
• Where to look for reserves for revenue growth?

Key findings:

1. Apply the Pareto principle — a small number of products produce the most results. Focus on them.
2. Conduct analysis regularly — the sales structure is changing, and product categories must be revised
3. Differentiate your approach — products of categories A, B and C require different management strategies
4. Automate the process — modern systems can conduct ABC analysis automatically and offer ready-made recommendations
5. Make data-driven decisions — ABC analysis removes subjectivity and shows the real picture

Remember: ABC analysis is not a one-time event, but a regular practice that should become part of your management system. Companies that systematically use this method gain a significant competitive advantage through more efficient use of resources.

Start with a simple revenue analysis, master the methodology, and then deepen the analysis by adding other parameters and combining it with XYZ analysis. The key is to act on the data you receive and continuously improve your business processes.