The Pareto Principle: Going beyond the 80:20 rule

The Pareto Principle has really stood up to the sands of time. When this clever theory was first condoured up, who would have thought we would still use it over hundred year later? 

How much do you really know about your assortment? Do you know which items offer the greatest return or which are most important to your customers? Equally, do you know which items are costing you money? This article highlights 5 ways Pareto can help you to help boost the profitability of your assortment, minimise risk and help you manage your inventory more effectively.

It’s no secret that for many businesses, 80% of turnover is generated by just 20% of the assortment. Given that such a large proportion of the assortment seemingly offers such little value to the business, you would be forgiven for focusing all of your attention on the best performing lines. Inventory decisions should not be taken lightly and businesses should strive to manage their entire assortment as effectively as possible.

Optimise your assortment

How can you be sure that you are making the right inventory decision? After all, while a slow moving line may seem like a costly waste of space in your DC, for certain customers, these items could well be the main reason they buy from your business. Equally, if an item offers only a minimal return in terms of customer benefit or profit, is it worth investing time and money ensuring this item is always available?

A well-structured Pareto analysis can indicate the performance of the assortment and highlight areas which require more attention. From service levels to stocking decision, the insights provided by the Pareto in the form of a ABC stock analysis should be used as a driving force to shape your assortment and optimise the performance of all your items.

The Pareto Principle is all about focus

How you define the boundaries within your assortment will depend heavily on what KPIs are most important to your business. Essentially, there are two main objectives which determine the KPIs: on one hand the focus can be on the profit margins of an item or the turnover. Alternatively however, the financial elements can be put to one side and customer satisfaction in the form of order lines or transactions can be used as the foundation on which to build KPIs. However, in addition to this, the following questions must also be raised when determining which category each item falls into:

• What items should be included? Which items should not be grouped?
• What are the basic criteria for ABC analysis?
• Dynamic or static? How often should ABC be recalculated?

Step 1: Differentiate your service level

In the context of assortment management, a service level is the target % of all ordered pieces of an item that can be delivered from stock at the first requested delivery date. Given that A-line items are those which are most important to the business, whereas C-line items are likely to be slowing moving items which offer a much lower return, there is little point in setting the same service level targets.

For A-line items, the service level target should be the highest of the three categories. On the other hand, considering that B and C class items are likely to have a lower overall impact on your business’ strategic goals, setting an excessively high service level target could result in unnecessarily costs yet deliver only a small return. As a consequence, it is essential that service levels are considered carefully in order to ensure that they are both realistic and relevant to the goals of the business.

Step 2: Determine the right stock levels

Once you have defined the desired service level for each classification, you can continue to re-assess you inventory policy. Given that the level of insurance inventory will differ depending on the importance of each item, it is enviable that A-line items are likely to have a greater requirement for safety stock as going out of stock could cost the business dearly.

However, this is not simply a case of investing heavily in safety stock for your best performing lines while ignoring C-line items. While insights from a well-structured ABC analysis can be used to guide a differentiated approach to service levels, there are still a number of factors that have to be taken into account. For instance, could certain items have a political impact on the business which require special attention? Or are there already contractual or customer obligations in place?

Through using the Pareto Principle to assess the inventory requirements of each category, your business can optimise stock levels in order to ensure that, where required, demand is covered with safety stock while cutting excess stock across the rest of the assortment.

Step 3: Make more informed stocking decisions

In addition to optimising inventory levels, the insights from conducting an ABC analysis may identify further opportunities to refine the assortment. For instance, some C line items may actually not be worth stocking at all as they simply do not offer a significant enough margin to justify holding on stock. Alternatively, there may be a number of items which are currently non-stocked which would actually be better to keep stocked at all time. This is particularly true for items where there is either a lengthy lead time or low level of supplier reliability.

Through utilising the insights from an ABC analysis to decide whether or not to change the stocking status on an item, you can boost customer satisfaction by ensuring the most important items are readily available. Equally, through using the Pareto Principle to refine your assortment, you can remove items which do not contribute towards achieving the overall business goals. This in turn can help free up working capital which can then be reinvested elsewhere in the business.

Step 4: Optimise here, optimise there

With clear insight into which items have the biggest impact on your ability to achieve your strategic goals, you can prioritise areas which require the most attention. Whether this mean taking time to re-negotiate lead time or order quantity with suppliers or develop more effective means of managing such items, the outcomes of the ABC analysis will aid you when structurally improving the way you manage your inventory.

When you consider that your A-line items are likely to be the best performing lines, negotiating more favourable lead times, or even better prices, could have a major impact. Likewise, for items which you identify as slow movers, the opportunity may arise to negotiate a smaller order quantity which in turn will result in you holding less stock.

While on an article level, these relatively minor developments may only seem to have a small impact, across the entire assortment, these can soon add up. In turn, such action can help improve overall availability, reduce inventory cost and generally improve efficiency across the board. Through utilising the ABC analysis, you can clearly see exactly where you need to prioritise time and resources in order to deliver the most value to the business.

Step 5: Monitor, report, review

Given that the previous 4 steps could have large potential impact on the performance of your business, it is important to monitor the effectiveness of inventory decisions in order to ensure you are moving in the right direction.

While overall stock value or overall availability could be used to compare year on year performance, unless you dig a little deeper, you will not be able to identify exactly which aspects of your assortment are performing well and which require more attention. Given that the service levels for each category are likely to be driven by very specific objectives, categorising items according to ABC classifications is a powerful way to monitor the evolution of your assortment.

Through reviewing each category that arises as a result of the ABC analysis, you can gain a much clearer picture of how your assortment is performing. Consequently, this provides you with time to investigate potential problem areas and respond accordingly. Furthermore, these categories provide a solid basis on which to report such developments to other areas of the business.