The Pareto Principle and its application in the Supply Chain

Work smart, not hard. This widely popular phrase in today’s corporate world—emphasising the importance of focusing efforts on what truly delivers results—neatly sums up the essence of the Pareto Principle.

The Pareto Principle suggests that 80% of outcomes stem from just 20% of the causes. To support this idea, Vilfredo Federico Damaso Pareto conducted various empirical studies. The most well-known of these was his observation that approximately 80% of Italy’s land (and therefore its agricultural yields) was owned by just 20% of the population. It is also said that he noticed a similar pattern in his own garden, where 20% of the plants were responsible for producing 80% of the fruit. This idea—that 20% of actions or causes drive 80% of results—is why the Pareto Principle is also commonly referred to as the 80/20 rule.

When applied to supply chain management and inventory control, this principle suggests that eight out of every ten euros in revenue come from just 20% of the product range. But we’ll delve deeper into this later in the article.

What is the Pareto Principle?

As we mentioned earlier, the Pareto Principle is a statistical idea that explains how results are often unevenly distributed—typically in an 80/20 split—where a small number of causes lead to most of the effects. This concept was introduced by the Italian economist Vilfredo Pareto in the late 19th century.

It’s not a strict mathematical rule but more of a helpful guideline for spotting patterns of imbalance. The exact ratio isn’t always 80/20—it could be 70/30 or even 90/10—but the key takeaway is the same: a small portion of inputs tends to drive the majority of outcomes.

By applying the Pareto Principle, businesses and individuals can use resources more effectively, set the right priorities, and focus on what truly makes a difference.

Examples of the Pareto Principle

The Pareto Principle can be seen in many different areas. Here are some of the most common examples:

1. In business management

In business, it’s often the case that 20% of internal processes lead to 80% of operational results. A small number of strategic initiatives tend to drive most major improvements in a company. Likewise, a small percentage of employees often account for the bulk of productivity, which is why it’s so important to recognise and retain top talent.

2. In marketing

Marketing strategies also follow this pattern. Usually, 20% of campaigns generate around 80% of the overall impact. The same applies to web traffic, a handful of keywords tend to bring in most of the visitors to a website.

3. In supply chain

When managing inventory, companies often find that a small number of products make up the majority of total stock value. Because of this, it makes sense to focus more attention on those key items. We’ll look at this in more detail later, along with how the ABC method can help businesses manage their product range more effectively.

Similarly, in procurement, 20% of suppliers are typically responsible for 80% of total purchases, making it essential to build strong relationships with these key partners.

4. In daily life

The Pareto Principle can also be applied to our everyday lives. For example, 20% of the tasks we do in a day often lead to 80% of the results we achieve. Similarly, in our professional networks, it’s typically 20% of the people who provide most of the job or business opportunities. This highlights the importance of nurturing and strengthening those key relationships.

These examples show how the Pareto Principle can help identify the areas where we should focus our efforts, optimising resources and maximising results.

Benefits of applying the Pareto Principle

In business, the Pareto Principle offers a range of practical and strategic benefits.

Resource optimisation

One of the main advantages is the optimisation of resources. By applying the Pareto Principle, organisations can pinpoint the areas that have the biggest impact and focus their efforts there. This helps avoid wasting time on unproductive activities and ensures better overall performance.

Improved decision-making

Another key benefit is improved decision-making. By relying on data that identifies the key drivers behind outcomes, companies can make better-informed and more strategic decisions, positioning themselves more effectively in the market. This approach also enhances operational efficiency, as it helps streamline processes and eliminate bottlenecks, ensuring that resources are directed where they matter most.

Higher profitability

When it comes to profitability, focusing on the 20% most valuable products or customers allows companies to significantly increase their profit margins. This is also supported by cost reductions, as businesses stop investing resources in low-impact activities or products and instead redirect that budget to more effective initiatives.

More satisfied customers

Applying the Pareto Principle can also greatly improve customer satisfaction. By focusing on the products, services, or processes that deliver the most value to customers, businesses can strengthen their relationships with them, leading to greater loyalty and a more positive brand perception.

Applying the Pareto Principle to inventory management

A common challenge in inventory management is deciding which products to focus on. Companies often end up investing too much money in products that don’t add significant value, while the ones that really matter might not receive the attention they need. This is where ABC analysis comes in, a methodology that helps us prioritise products and optimise our supply chain.

Differentiated inventory management

One of the clearest advantages of ABC analysis is that it enables differentiated inventory management. For A products, much stricter inventory policies are implemented. This might include daily or weekly inventory reviews, along with more frequent replenishment policies to ensure these key products are always in stock.

Optimising inventory and reducing costs

ABC analysis helps us optimise our inventory levels, particularly when it comes to C products, which often make up a large portion of storage costs without adding much value. By keeping these products at minimal levels or managing them on demand (if possible), we can free up warehouse space and reduce the capital tied up in stock.

Demand planning

With ABC analysis, we can also improve our demand planning. Knowing which products are most important allows for much more accurate forecasting. For example, if we know that A products are critical to the business, we can ensure our demand planning processes are finely tuned for those items. In contrast, C products can be managed less frequently, reducing costs and complexity.

Common mistakes in applying the ABC method

Many companies use ABC analysis, but that doesn’t always mean they’re making the most of the information it provides or applying it correctly. In fact, here are some of the most common mistakes made when carrying out traditional ABC analysis:

Insufficient demand forecasting control

A common mistake is focusing solely on historical data without considering future demand forecasts in the ABC classification. What happens, for instance, with trending products? If we only rely on past data, we risk misclassifying items that are on the rise or those on the decline. And what about seasonal items? If we’re approaching the peak season for a seasonal product and only looking at past data, our classification and subsequent decisions won’t align with the product’s current situation.

Relying on a single analysis criterion

We’ll go into more detail on this later, but it’s crucial not to base everything on just one criterion. It’s essential to cross-reference different criteria to make sure the results are much more accurate and valuable for the company.

Failing to update the ABC analysis

In many cases, the ABC analysis is done at a specific point in time and then left unchanged for weeks or even months. It’s just as important to set the right rules for classification as it is to establish the processes for regularly updating the analysis. The frequency of updates will depend on each company, but it’s important to define this optimal update cycle.