ABC analysis is a method used in inventory management to categorize items based on their value and importance to the business. It helps businesses identify the items that are most and least valuable and focus on managing those items accordingly. In cost accounting, ABC analysis is loosely related but different from ABC analysis for inventory management. Accountants use activity-based costing in manufacturing to assign indirect or overhead costs like utilities or salaries to products and services.

ABC analysis in inventory management classifies inventory items into three categories based on their value and importance to the business: A (high-value items), B (medium-value items), and C (low-value items) . The "A" classification usually involves 5% of the total number of inventory items, while the "C" classification pertains to 80% of the inventory items. The breakdown can then be used to exercise high levels of monitoring over "A" classification inventory, and the least monitoring over "C" classification inventory.

ABC analysis provides businesses with greater control over their inventory. By focusing on the A items, businesses can better manage their inventory levels and avoid stockouts. It helps businesses make better decisions about which items to stock and how to manage them. ABC analysis can be used in a variety of ways in inventory management, such as to prioritize inventory, optimize inventory levels, and improve pricing strategies.

The most common challenges while using ABC Analysis are that the process requires detailed data on the items being analyzed, and it can be time-consuming to gather and analyze the data. Additionally, it can be difficult to determine which items should be classified as “A”, “B”, or “C”. ABC analysis is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.