In hospitals, more than a third of the budget is allocated to supplies. According to a case study by the SAC College of Pharmacy, introducing inventory control measures for managing the most expensive medicines in a 1500-bed government-run hospital can reduce costs by up to 20%. In other words, managing your inventory and implementing good controls have a direct impact on the bottom line.
ABC analysis is a commonly used inventory management technique. It determines the value of inventory items based on their relative importance to the business. Items are ranked based on demand, cost, and risk and classed accordingly so that healthcare business leaders can understand which items are most critical to the success of their organization.
ABC Analysis and the Pareto Principle
According to the Pareto Principle, most results come from 20% of efforts in a system. Based on this rule, ABC analysis identifies the 20% of goods that deliver 80% of the value. Most businesses have a small number of Class A items with high profitability. These are the most important items in the organization, with high annual consumption values.
Class B items are interclass items, with consumption values that are lower than Class A items but higher than Class C items. Class C items have the lowest consumption value, with a high proportion of lines and low consumption values.
Inventory management varies according to each class and their relative importance. Stock management is costly, which is why there should be a balance between the measures taken to protect the stock and the value at risk if a loss occurs. For example, controls and records for Class A goods must be tightly managed, while the lower-value Class C group can be managed with basic controls as the value at risk is lower.
How is ABC analysis calculated?
You can determine which inventory class items belong to by multiplying its annual sales by its cost. This will determine which goods are high priority and which yield a low profit, so you know where to focus your efforts and resources.
This calculation can be expressed in a simple formula:
Annual usage value per product = (Annual number of items sold) x (Cost per item)
Start by identifying your key objective, i.e., would you like to lower procurement costs or raise cash flow by optimizing inventory levels of Class A items?
Then, collect data related to the annual spend on each item in raw purchase dollars. Sort your inventory items by cost, from high to lowest impact, and then calculate the impact on sales as a percentage using the formula above.
Once you’ve processed the data, you can define the items into classes and schedule reviews to determine a course of action, whether it’s contract renegotiation, vendor consolidation, or implementing procurement changes.
Let’s use the example of a hypothetical hospital pharmacy to demonstrate what this calculation would be like in practice. The pharmacy arranges the expenditure of specific medicines in descending order and calculates the cumulative cost of all items, then the cumulative percentages of expenditure and the number of items calculated. Based on these calculations, the pharmacy split its inventory into Groups A (70%), B (20%), and C (10%):
- 10% of medicines (Group A) cost 70% of the budget
- 20% of medicines (Group B) accounted for 20% of the budget)
- 70% of medicines (Group C) accounted for 10% of the budget
By conducting an ABC inventory analysis, the pharmacy was able to determine the demand and the cost of medicine and was able to identify which medicines required the most stringent control to optimally use the budget allocated to them. They were also able to reduce overhead costs.
The Benefits of ABC Analysis in Medical Inventory Management
Applying ABC analysis to your inventory management has several key benefits:
- Inventory Optimization: An analysis can reveal which products are most in demand so that healthcare facilities adequately stock those goods and maintain lower stock levels of Class B or C items where appropriate.
- Forecasting: Monitoring and collecting data about products with high customer demand can improve forecasting accuracy and increase overall revenue for the hospital or facility.
- Informed Profitability: By identifying which items account for 70-80% of the revenue, companies know where to negotiate better terms with suppliers in order to boost revenue. By negotiating down payment reductions or shipping costs, profitability will increase.
- Improved Resource Allocation: When demand decreases, items can be reclassified to ensure that resources are allocated appropriately at all times.
- Improved Communication and Customer Service: Determining which products are the most profitable should inform external marketing communications and service levels for these items.
- More Appropriate Controls: Class A inventory items are closely related to the profitability and success of the facility, which is why stock levels and controls should be closely monitored and managed.
- Cost Savings: By carrying the correct proportion of stock based on their classification, inventory costs can be reduced by eliminating excess inventory.
ABC analysis offers major benefits for businesses, but conducting the analysis manually will be time-consuming. Find an inventory management partner that can automate inventory management and optimization and streamline the process in order to realize those benefits.