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Focus on critical issues by conducting an ABC analysis

Learn to differentiate between relevant and irrelevant issues in a case interview

The ABC analysis is based on the pareto principle and helps in prioritization of key issues. The method creates a transparency showing significance of various revenue segments. For instance, an ABC analysis can be used to segment product lines as important/less important according to their share of sales or the overall value they provide to the company.

Using the ABC analysis, a company's material selection can be divided into A-, B- and C-goods. Lets assume that “A-goods” are materials that are often scarce and have a high value per unit. Consequently, a few units of "A-goods" account for significant revenues (as share of the total revenues). In addition, “C-goods” have a low value per unit with no scarcity within the company. Thus, whenever you are asked which materials are “strategic” or worth of being looked at, your answer should be: “Let’s focus on A-goods first” to focus on items with the highest impact with minimal efforts.

Conduct an ABC analysis to tackle the right cost blocks within a supply chain optimization

Suppose you have determined that an automotive company is making losses due to high working capital within the supply chain (see value chain for more infos). What could you do to reduce the working capital?

Since you need to cut costs you should first focus on the right cost blocks. Try to cluster your inventory based on its stock quantity and value by conducting an ABC analysis. You will quickly notice that most of your working capital is tied up for the purchase or production of motors. Compared to other materials such as screws, there a only a few motors on stock, but they are extremely expensive. In addition, because they are considered as “important”, the head of production insisted on a high safety stock. But, through advanced demand planning and a just in time delivery, you determine that you could reduce the inventory level and cut costs significantly. Moreover, you can possibly even increase the availability (reducing stock-out events).

Category
of Goods

% of
inventory SKUs

% of
inven
tory value

Example
(Automotive OEM)

A

10

80

Motors

B

15

15

Seats

C

75

5

Screws

Key takeaways

  • ABC analysis is a simple method of prioritizing issues.
  • The analysis classifies different kinds of products based on their value or share of sales.
  • This differentiation provides a better understanding of the anatomy of the cost structure and a good foundation for further analyses.

2 Comment(s)
October 10, 2014 01:31 -
ritika

Luis, thanks for pointing this out to us. This is a great observation and must be asked during the interview in the form of hypothesis. Example hypothesis: "We can reduce the inventory that is not being sold quickly, do we have any data that categorizes turn over rates or data that indicates time to be an issue". Based on the answer, you can come up with a recommendation.

May 22, 2014 04:41 -
Luis Miguel

The above table indicates that a small portion of inventory holds the highest value, when compared to other categories. The table doesn't indicate which category achieves the highest inventory turnover. Here's the answer to "so what?": inventory that isn't being sold quickly can be reduced going forward, and inventory that is sold quickly can be increased to accommodate demand.

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