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.

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.
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.
 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.
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