A Complete Guide to ABC Analysis in Customer Segmentation and Inventory
If you have ever heard of the 80/20 rule, there is a good chance that the person talking about it was referring to a form of ABC Analysis. ABC Analysis is a comprehensive way of segmenting your customers or products to make sure that you get the most out of your time and your resources when you’re servicing them by breaking the items down into three easily distinguishable categories.
In this article, you will learn 1) what the ABC analysis is, 2) why use the ABC analysis, and 3) how you can apply the ABC analysis to structure and prioritize your customer segments and inventory types.
ABC ANALYSIS DEFINED
ABC analysis is a method of analysis that divides the subject up into three categories: A, B and C.
Category A represents the most valuable products or customers that you have. These are the products that contribute heavily to your overall profit without eating up too much of your resources. This category will be the smallest category reserved exclusively for your biggest money makers.
For example, a software company might engineer different pieces of software, but one is a niche software that can be sold at a significantly higher price than the others. That’s why it accounts for about 60% of the overall revenue, although the company sells far less of these products compared to other software categories. Hence, this specific software is a category A product.
Category B represents your middle of the road customers or products. Many wrongly approach this group as those who contribute to the bottom line but aren’t significant enough to receive a lot of attention.
Yet, category B is all about potential. The members of this category can, with some encouragement, be developed into category A items.
Category C is all about the hundreds of tiny transactions that are essential for profit but don’t individually contribute much value to the company. This is the category where most of your products or customers will live. It is also the category where you must try to automate sales as much as possible to drive down overhead costs.
THE PARETO PRINCIPLE
ABC analysis is based on what is called the Pareto Principle, an economic principle created by the economist Vilfredo Pareto. Pareto gained notoriety for saying that most economic productivity comes from only a small part of the economy. Essentially, it shows that there is an unequal relationship between your input and your output.
For example, a business might get 80% of its results from only 20% of its staff. This demonstrates that 20% of the staff are more productive than the other 80% of the team.
Another common example of the Pareto Principle suggests that you get 80% of your sales from only 20% of your customers. In this case, these 20% would be your category A customers, hence, those who make the biggest contribution to your revenue. Basically, only 20% of your customers are valuable enough that losing one would significantly hurt the business.
You can bring the Pareto Principle even further into ABC analysis when you consider lifetime value. The relationship between your input and output plays a major contribution in a customers’ lifetime value. It also forms the foundation of ABC analysis by providing guidelines for breaking down customers into different groups (A, B and C).
WHY USE ABC ANALYSIS?
The main use of ABC analysis is to improve your ability to deal with large and complex data sets by breaking them down into three segments. These segments define the priority of the data within whatever area you are using them in.
Once the data is broken down into segments, it is easier to focus on the data and use it in a meaningful way. Breaking down the data into these segments makes specific issues in the data more obvious. It also helps in prioritizing the different segments.
For example, ABC analysis can be used to segment your customers and break down customer-specific data.
First, you would divide the customers into each of the three categories based on the sales volume the customer provides. Then, you would consider how that volume relates to your margin contribution.
If you segment the customers successfully, the customers with the most value will go into the high priority category A, while less important customers would be placed in the bottom category C. Customers that are somewhere in between will stay in category B.
The segmentation allows you to pinpoint your most valuable customers. It then allows you to examine them separately so that you can form a plan of action. When you can look at things in three different categories, it is easier to allocate your resources in a more strategic way than it is if you’re flitting back and forth between charts or just trying to make sense of heaps of raw data. The benefit of taking this extra step is that it makes it easier to analyze the data strategically which in turn makes it easier to maximize your profits.
EXAMPLE 1: HOW TO USE ABC ANALYSIS IN CUSTOMER SEGMENTATION
ABC Analysis is performed within customer segmentation as a way to pinpoint your most valuable customers. Here’s how to use ABC analysis when creating customer segments based on value:
Performing the ABC Analysis
To perform the analysis, you’ll need to start by looking at four primary metrics for each of your customers: sales revenue, revenue potential, contribution margin and support costs.
Use these four categories to create four different charts. Rank your customers according to each category and place them on the chart.
Then, compare the charts, specifically the sales revenue and contribution margin charts. With this comparison, you can begin to break down your customers into the three groups: A, B or C.
Your most valuable customers will live in A. These customers will bring in a lot of revenue and make up a significant portion of the contribution margin. Ideally, they’ll be close to the limit in terms of revenue potential.
The second tier customers will live in B. These customers will be loyal customers and they will spend a good amount of money with you on a regular basis. However, these customers will not be spending as much as they could be.
Category C is made up of the rest of your customers. Category C includes people who turn up every once in a while and make a purchase. It might also include those consistent customers who make a lot of small purchases. These customers will spend money but won’t contribute very much to your overall sales and profit. These customers also tend not to have much potential.
By looking at your customers in terms of profit margin and potential, you’re creating a multi-dimensional view of your customers. Sales figures alone can be misleading. Seeing a customer who makes a weekly purchase for a small amount might trick you into thinking they are a valuable customer when they really are not.
This perspective is particularly useful for dealing with the customers who lie in the no man’s land that is category B. These are the customers that you know are valuable. But until you analyze their potential, you’re not sure how valuable they really are. Using ABC analysis gives you a better idea of not only what they spend but how they spend it. Better yet, it tells you if the customer could be spending more.
Rather than looking at sales figures, you’re looking at data that is actionable. Using this data enables you to make real decisions that will increase your revenue.
How to Interpret the Data?
Get out your charts and your list of segmented customers again.
Take a look at the potential revenue charts. You will notice that some of the customers in the B category have the potential to be in the A category. This is revenue that you’re missing out on, perhaps because you’re not allocating enough time or the wrong resources to the customer.
To figure this out, look at your resource allocation chart and look at where you’re sending your teams and your money. Start with category C. A lot of companies over-emphasize the importance of these customers and spend too much time or money servicing their needs. Look at how your sales teams are divided to see who spends time with these C customers.
With this in mind, move into the B category. Look at who is servicing these customers and how often they are being serviced. Could this be improved? Make sure that these customers are not being inadvertently neglected.
Then, look at what at what B customers are buying and how often they are buying it. Is there another product they need that no one is selling them? Could these customers benefit from an upgraded version of the current product? What could you do to further meet the customers’ needs and encourage them to spend more money?
Finally, check out category A. For many companies, category A tends to be top heavy in terms of service. Certainly, these are the customers that demand most of your time and resources. However, are you over-extending your resources here?
The problem with servicing category A customers is that you desperately want to keep them happy. However, if they’re spending that much money with you, there is a good chance that they are not going to leave you just because you aren’t smothering them with attention.
Take a hard look at the resources you allocate to category A customers. Determine whether there’s opportunity to share those resources with category B customers and transform them into A-level customers.
EXAMPLE 2: HOW TO USE ABC ANALYSIS IN INVENTORY
ABC analysis is also an excellent tool for inventory control. It is particularly useful for determining which of your inventory items impact your inventory cost the most. It also provides a framework for determining the best ways to manage and control your inventory.
Using ABC analysis in inventory control includes the same principles used in customer segmentation. Essentially, not every item in your inventory has equal value. You’ll use this method to determine the real value of each item in your inventory and then place it into the A, B or C category based on its importance.
Performing the ABC Analysis
There is no threshold for determining which products go into which category. The category thresholds need to be defined specific to your company if you want to be able to interpret that data in a way that is meaningful for your business.
However, the same principles apply when creating the categories. Category A is the smallest category made up of the most valuable products. Category B is slightly larger with products that have less value. Category C is the largest category, full of products that contribute to your bottom line but each in a very small way.
Here is an example of some common threshold figures for these categories:
Category A: 20% of your products, making up 70% of your annual consumption
Category B: 30% of your products, making up 25% of your annual consumption
Category C: 50% of your products, making up 5% of your annual consumption
Here is a useful way to divide up your products into categories:
- Multiply the annual number of items by the cost per item to calculate the annual usage value for each product.
- List each product in descending order according to product usage value.
- Total up the usage value and the number of items.
- Translate each item and its usage value into the fraction or percentage of the cumulative total.
- Create a chart to connect the number of items and the usage value. Divide the chart up into A, B, and C at the points where the curve begins to change sharply.
How to interpret the Data?
Look at how you control the products in each category. Check out the costs associated with keeping these products in stock.
If you’re currently making uniform purchases, you’re probably either over-ordering or under-ordering the vast majority of your products. This means that your storage, delivery and management costs are higher than necessary.
Instead of ordering your entire stock through the same method, you might save the most sophisticated ordering system for your category A items. It is also best to improve the managerial oversight of these items to make sure that the purchase orders are correct. It is okay to decrease your supply level of category A levels and employ more man hours because these are the products most worth your while.
For category B items, you might consider ordering more stock to include a safety stock level. This will reduce delivery costs, ordering time and the amount of time dealing with stock.
Leave C items on automated ordering to avoid allocating too many resources to them. Keep plenty of the C products in the warehouse so that you don’t have to worry about ordering them.
Following these rules can reduce the amount of man hours dedicated to your inventory, your inventory costs and the amount of time you spend ordering products.
You can also look at another example of an ABC inventory analysis.
ABC analysis is a great way to transform your data into actionable measurements that you can use to reduce overhead costs and drive profits. Remember that the best way to use this model is not to force yourself into the 80/20 rule but to use is as a guideline for determining who your most valuable customers are and what you can do to get more of them.