Have you heard of the Pareto principle? The Pareto principle is also known as the 80/20 rule, the law of the vital few or the principle of factor sparsity. It was created by Italian economist Vilfredo Pareto who observed the 80/20 connection.
The rule suggests that for most events, including business events, 80% of the results/effects come from 20% of the activities. For example, 80% of turnover comes from 20% of the products. Or, 80% of inventory cost is utilized by 20% of the inventory.
Chances are you have observed the effects of the Pareto principle at least once in your career. In fact, even for the untrained eye, the Pareto principle might appear to be an obvious phenomenon. If used effectively, the Pareto principle can help a business achieve operational efficiency at scale.
Here are some common Pareto principle business scenarios
IKEA, the Swedish furniture maker, has about 12,000 products. Some of those products – like the Lack coffee table, malm bed, and Klippan sofa, for example –bring in more revenue than the rest of the products put together. In other words, 20% of the product line contributes to 80% of IKEA’s revenue.
Similarly, for every business, there could be products that b in more revenue than the rest of the products. It could be due to a variety of reasons like direct problem solving, durability, status symbol, price point, etc. If you can identify which products fall into that 20%, you can easily maximize the 80% of your revenue by dedicating more resources for their expansion.
The Pareto principle applies not just to businesses selling products but also in marketing and winning new customers. An average business has to launch numerous marketing campaigns to meet its revenue goals, but not every marketing campaign will have the same efficacy. While some campaigns bring in the desired results, there may be other campaigns that do not perform well.
In such cases, it would be 20% of the marketing campaigns that will bring 80% of the results. The maximum number of website traffic, leads and even sales — everything could come from the top marketing campaigns and not all campaigns equally.
Professional warehouses deploy what is known as the ABC system of inventory management. Under the hood, the ABC model of inventory management works the same way as the Pareto principle.
While the Pareto principle advocates the 80/20 rule, the ABC system follows a method of prioritizing inventory based on their cost, monthly revenue, profit or risk of stock-out.
Depending on these variables, inventory is segmented into each category — A, B or C.
• A items - bring in top 80% revenue and typically could be 10 to 20% of the total inventory.
• B items -bring in 15% of revenue and typically occupy 30% of total inventory.
• C items - bring in the remainder 5% of revenue and typically occupy 50% of total inventory.
Based on the ABC analysis, warehouse managers can draw up plans to ramp up warehouse storage capacity, planogram locations and record-keeping for A-grade items. In other words, warehouse managers can double down on the inventory management process for A-grade items which bring in 80% of the revenue.
Let’s take the example of Acme Airlines which has several airplanes. To ensure smooth operation, Acme Airlines also has a backup inventory of airplane engines, landing gear, screws, bolts and so on.
Of all the inventory that the airline owns, engines are the most expensive of the lot while their quantity is minimal. If a quick number-crunching exercise is carried out, it would show that 80% of the airline’s stock cost is made up of engine costs. The rest of the inventories will occupy the remainder of 20% of the stock cost.
Given this situation, it is easier for warehouse managers to create tighter inventory management controls for engines. This helps reduce the loss of stock due to theft or pilferage, damage due to external conditions or even obsolescence due to negligence. Also, a thorough process of procurement based on bids from multiple vendors, quality assurance and records management would have to be followed for these products.
The ‘B’ and ‘C’ category of inventory require inventory control but not to the level of ‘A’ grade inventory. The warehouse manager can buy them in bulk quantities, run sample-based quality checks and maintain average stock levels to avoid stock-out situations.
The Pareto Principle is used in business in several forms. One of its obvious applications is in inventory management where the cost and the risk involved is higher than in other operations. Applying the Pareto principle to identify inventory of high value and exercising tightened inventory control measures for them will help your business reduce inventory loss and stock-out situations.
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