Explain ABC analysis in Cost Accounting

ABC analysis is an inventory classification method, in which inventory is divided into three categories: A, B, and C in descending order of value. A has the highest value, B has a lower value than A, and C has the lowest value.

Generally speaking, inventory management and optimization are essential for companies to help control costs. ABC analysis achieves this goal by allowing management to focus most of its attention on a few of the most valuable products (item A) rather than many low-value trivial items (item C).

The goal of ABC analysis: The ultimate goal of ABC analysis is to ensure economy through effective material management. It also has the purpose of formulating policy guidelines for selective control. Faced with a large number of projects, when material management is confused and needs attention, ABC analysis helps managers distinguish projects, first focusing on the most important projects, then second-class projects, and then the rest-third grade.

ABC analysis rules:

It can be seen that the ABC analysis and the Pareto principle have similar ideas. The Pareto principle states that 80% of the total consumption value comes from only 20% of the goods. Simply put, this means that 20% of your products will bring in 80% of your income.

ABC analysis works by breaking it down in the following ways:

• A-items: 20% of all goods contribute to 70-80% of the annual consumption value of the items
• B-items: 30% of all goods contribute to 15-25% of the annual  consumption value of the items
• C-items: 50% of all goods contribute only 5% of the annual consumption value of the items

In order to calculate the annual consumption value of any item or items:

Annual consumption value = annual demand x item cost per unit

That way, the manager can determine which goods bring in the most value and separate those from the numerous goods that provide little profit.

ABC analysis is widely used in supply chain management and inventory inspection and inventory systems and is implemented as a cycle counting system. This is most important for companies seeking to reduce working capital and holding costs. This is done by analyzing excess inventory and obsolete inventory by making way for easy-to-sell goods. This helps to avoid keeping working capital available instead of tying it to unhealthy inventories.

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