Hello everyone. In this video, you'll learn how to apply the 80/20 rule to classifying inventory by an ABC analysis. ABC analysis is a technique first introduced by General Electric, GE, to classify inventory for raw materials. The method classifies items of different importance into A, B, and C types or classes of inventories depending on their percentages of the total spend or consumption, and then use different inventory strategies to manage them. The key idea, lying behind the ABC analysis is the 80/20 rule. That is, we like to focus on the critical items, often a small percentage of the total, say 20 percent that drives the majority of the cost, say 80 percent. In the extreme cases, class A may include 10-20 percent of the items that account for 60-80 percent of the cost. Class B, may include 20-30 percent of the items and account for 20-30 percent of the cost. Class C, includes all the rest. That is, the majority, 50-70 percent of the items but, only accounts for less than 20 percent of the cost. Just think about your household. How many of the items you use on a regular basis, like daily? How many of them are sitting there just in case you need them, like once a year? To do an ABC analysis, you can follow these simple steps. First, determine the usage, annually, monthly, or weekly, and so on in units of each item. Second, multiply the usage by the unit cost to get the spend or consumption for each item. Third, rank the spend or consumption from high to low. Fourth, calculate the cumulative spend in dollar value and in percentage. Finally, classify the items into A, B, C classes or types, and draw the Pareto chart. Let me illustrate the steps by an example. Here, we have 10 items with different usage, let's say annually, in units and different unit cost. We calculate the spend or consumption in dollar value for each item, by multiplying the usage with the unit cost. Then, we rank the items by their spend from the highest to lowest. Screenshots of these steps in software will be shown shortly. Now, we rearrange the items by their ranks and calculate the cumulative spend in dollar value. For example, the cumulative spend of the first item, is its spend. The cumulative spend of the first two items, is the sum of the spend of the first item and the spend of the second item and so on. After we calculate the cumulative spend for all the items, that is, the total spend, then we can use the total spend, which is $8,470 in this case, as the denominator to calculate the cumulative spend in percentage for every item here. For instance, dividing the cumulative spend of the first item, which is $5,950, by the total spend, we get 70 percent for the cumulative spend in percentage for the first item. Finally, we can determine class A, B, and C for these items. Item six is the class A item because it alone accounts for 70 percent of the total spend. Items two and seven are class B items because they account for 19 percent of the total spend. All the remaining seven items are class C items. Despite they're majority, they only account for 11 percent of the total spend. We can visualize the classification by a Pareto chart where the bars show the spend of individual items and the curve shows the cumulative spend in percentage. It is much easier to identify A, B, and C items by this chart. You can generate this chart by a software and I'll show you the screenshots shortly. To summarize the example, an ABC analysis on the spend shows that the total cost is around $8,470 annually. Out of the 10 items, one item, which is 10 percent, consumed 70 percent of the cost, that is, the A item. Two items, that is, 20 percent, consumed 20 percent of the cost, these are the B items, and the rest seven items, 70 percent, consumed only 10 percent of the cost, so they are the C items. In practice, you may not encounter such an extreme case where the spend is so highly concentrated in a few items, but it still makes sense to apply the ABC analysis.