ABC analysis

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ABC anaysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, [1] while also providing a mechanism for identifying different categories of stock that will require different management and controls.[2] When carrying out an ABC analysis, inventory items are valued (item cost multiplied by quantity issued/consumed in period) with the results then ranked. The results are then grouped typically into three bands[3]. These bands are called ABC codes.

ABC codes
1. "A class" inventory will typically contain items that account for 80% of total value, or 20% of total items. 2. "B class" inventory will have around 15% of total value, or 30% of total items. 3. "C class" inventory will account for the remaining 5%, or 50% of total items.

ABC Analysis is similar to the Pareto principle in that the "A class" group will typically account for a large proportion of the overall value but a small percentage of the overall volume of inventory. Another recommended breakdown of ABC classes[5]:
1. "A" approximately 10% of items or 66.6% of value 2. "B" approximately 20% of items or 23.3% of value 3. "C" approximately 70% of items or 10.1% of value

Advantages, Disadvantages and Limitations of Activity Based Costing (ABC) System:

Advantages of Activity Based Costing System:
Activity based costing system has the following main advantages / benefits:

1. More accurate costing of products/services, customers, SKUs, distribution channels. 2. Better understanding overhead.

3. Easier to understand for everyone. 4. Utilizes unit cost rather than just total cost. 5. Integrates well with Six Sigma and other continuous improvement programs. 6. Makes visible waste and non-value added activities. 7. Supports performance management and scorecards 8. Enables costing of processes, supply chains, and value streams 9. Activity Based Costing mirrors way work is done 10. Facilitates benchmarking

Disadvantages or Limitations of Activity Based Costing System:

Activity based costing system help managers manage overhead and understand profitability of products and customers and therefore is a powerful tool for decision making. However activity based costing has a number of limitations or disadvantages. These limitations or disadvantages are briefly discussed below:

1. Implementing an ABC system is a major project that requires substantial

resources. Once implemented an activity based costing system is costly to maintain. Data concerning numerous activity measures must be collected, checked, and entered into the system. 2. ABC produces numbers such as product margins that are odds with the numbers produced by traditional costing systems. But managers are accustomed to using traditional costing systems to run their operations and traditional costing systems are often used in performance evaluations. 3. Activity based costing data can be easily misinterpreted and must be used with care when used in making decisions. Costs assigned to products, customers and other cost objects are only potentially relevant. Before making any significant decision using activity based costing data, managers must identify which costs are really relevant for the decisions at hand. 4. Reports generated by this systems do not conform to generally accepted accounting principles (GAAP). Consequently, an organization involved in activity based costing should have two cost systems - one for internal use and one for preparing external reports.