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abc stock analysis

The pareto principle: Going beyond the 80:20 rule

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

How much do you know about your assortment? Do you know which items offer the greatest return or which items are the 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 boost the profitability of your assortment, minimize risk and help you manage your inventory more effectively.

It’s no secret that 80% of revenue is generated by just 20% of the assortment for many businesses. Given that such a large proportion of the assortment seemingly offers little value to the business, you would be forgiven for focusing 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.

Optimize 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 to ensure this item is always available?

A well-structured Pareto analysis can indicate the assortment’s performance and highlight areas that require more attention. From service levels to stocking decisions, the insights provided by the Pareto in the form of an ABC stock analysis should be used as a driving force to shape your assortment and optimize 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, two main objectives determine the KPIs: on one hand, the focus can be on the profit margins of an item or the revenue. 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 most important to the business, whereas C-line items are likely to be slowing moving items that offer a much lower return, there is little point in setting the same service level targets.

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

Step 2: Determine the correct stock levels

Once you have defined the desired service level for each classification, you can continue to re-assess your 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 guide a differentiated approach to service levels, several factors still have to be taken into account. For instance, could certain items have a political impact on the business which requires special attention? Or are there already contractual or customer obligations in place?

By using the Pareto Principle to assess the inventory requirements of each category, your business can optimize stock levels 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 optimizing inventory levels, the insights from conducting an ABC analysis may identify further opportunities to refine the assortment. For instance, some C-line items may not be worth stocking as they simply do not offer a significant enough margin to justify holding on to the stock. Alternatively, there may be several items that are currently non-stocked which would be better to keep stocked. This is particularly true for items with either a longer lead time or a low level of supplier reliability.

By utilizing 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, by using the Pareto Principle to refine your assortment, you can remove items that do not contribute to 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: Optimize here, optimize there

With clear insight into which items impact your ability to achieve your strategic goals, you can prioritize areas that require the most attention. Whether this means 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.

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

While these relatively minor developments may only seem to have a small impact on an article level, these can soon add up across the entire assortment. Such action can help improve overall availability, reduce inventory cost, and improve efficiency. By utilizing the ABC analysis, you can clearly see exactly where you need to prioritize time and resources to deliver the most value to the business.

Step 5: Monitor, report, review

Given that the previous 4 steps could have a large potential impact on your business’s performance, it is important to monitor the effectiveness of inventory decisions 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, categorizing items according to ABC classifications is a powerful way to monitor the evolution of your assortment.

By reviewing each category that arises from 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 for reporting such developments to other areas of the business.

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Ali Zaidi

Dennis Weir

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