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Date: 05/31/2018

ABC analysis is widely used in business. This analysis is used for inventory management, sales management, and cost management. Mistakes in the analysis can have severe consequences for the business. After reading this article, you will learn about the most common mistake in ABC analysis, where it may lead, and how it can be avoided. So, let's take a look at a case.

Business Case: Mistake at the Cost of Position

Business Case: Mistake at the Cost of Position

At one point, a very well-known FMCG company decided to increase its profits by changing the terms of its commercial policy. In order to encourage customers to buy large volumes, the company decided to change the terms for granting discounts and deferring payment to customers depending on what share of revenue they generate.

The analysts of the company were instructed to divide the customers using ABC analysis into groups according to the amount of revenue for the last six months. It was decided to use the Pareto Principle 20/80 (“20% of the indicators give 80% of the result, and the other 80% of the indicators is only 20% of the result”) as a way of dividing the customers. As a result, Group A had to include customers who contributed from 0% to 80% of revenue, in Group B from 80% to 95%, and in Group C from 95% to 100%. The customers in Group A were provided with the best conditions, while the customers separated into Group C had to work without a discount and on a pre-paid basis.

The commercial service quickly implemented a new policy, but three months after the implementation, revenue began to drop. In another six months, it dropped by almost 30%, and accounts receivable increased significantly. A commission was established urgently in order to understand the situation. This commission included employees from financial services and the internal audit service.

Within the week, the commission succeeded in finding the reason for the reduction in revenue and the increase in accounts receivable. This all happened because the company determined the ABC group boundaries incorrectly. The boundaries of Group A were determined on the assumption that 80% of the revenue was generated by 20% of the customers. In fact, the ratio was different: 63% of the revenue was generated by only 12% of the customers. Thus, Group A included the customers who received better conditions than they should have received, and the company incurred additional, unreasonable expenses selling goods to these customers.

As a result, the commercial director and several analysts lost their positions. The company changed the classification of the customers. Five months later the company increased revenue to 120% of the original value.


Why it is difficult to determine the boundaries of the ABC classes

Of course, this mistake could have been avoided if the effect of the changes to the terms of the commercial policy had been evaluated. Unfortunately, these calculations were not made. The main mistake that was made when performing the ABC analysis was using the Pareto Principle 20/80 to determine the ABC group boundaries.

The problem is not that the Pareto Principle does not work. If you look around, you will find that most of the results of the Pareto Principle are positive and they were achieved with little effort. The problem lies rather in the fact that most managers, like in the story above, do not understand that the 20/80 ratio discovered by Pareto is just a result of a statistical survey. This specific ratio cannot be regarded as a law of nature. In real life, the allocation of the contribution of a larger and smaller part can be any ratio: 10/90, 30/70, 1/99, etc. There are no unified values for determining the ABC groups. These values, like the number of groups, always depend on the data set being analyzed.

In order to avoid this mistake, when performing the ABC analysis, it is always necessary to calculate the group boundaries based on the data set being analyzed. To do this calculation manually is a quite difficult and time-consuming task. This is another reason why the 20/80 ratio is mistakenly applied. Therefore, the best thing is using a ready-made and proven solution. For example, add the Fincontrollex® ABC Analysis Tool for Excel to assist you in running an ABC analysis. For more details about this solution, please visit this page.

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