Most business owners understand the principles of the 80-20 Pareto Rule. The rule itself originated from Vilfredo Pareto, an Italian economist. This business rule states that most companies derive 80% of their revenue from the top 20% of their customers. The rule lends itself well to companies understanding the danger of losing any one of those clients occupying this top percentile, as well as the importance of leveling out business in order to avoid the consequences of a sudden and drastic loss in revenue.
The Pareto Principle and Your Company's Inventory
Given the current state of the economy, many companies have probably learned the hard way about the dangers of this rule. However, can the Pareto rule be applied to inventory management? If so, what does it mean and what insight can companies gain from applying the rule to how they manage their inventory?
In terms of inventory management, the rule implies that 80% of the fastest moving products in a company’s inventory are made up from the top 20% of its product lines. Therefore, it simply stands to reason that the remaining product lines are either slow moving or dead stock inventory. At the very least, the remaining lines are not immediate sellers and are often the cause of high inventory holding costs.
Tracking Causes of High Holding Costs With the 80-20 Rule
The longer inventory is held, the higher the holding costs and the more expensive that inventory becomes. Having a high inventory turnover rate on products means that those parts, materials or products a company buys, are immediately sold to its customers.
Some companies measure inventory turnover rate in hours, days, or weeks, but almost all consider it essential to sell products within a month of having purchased them. So, what can be done to mitigate the costs associated with these slow moving product lines and the high costs of holding them for extended periods?
- Quantify Value of Slow Moving Inventory
Many companies hold stock in order to capture opportunistic sales, or at the very least, to retain an important position in their market. These companies may not do a very good job of managing these products, or may not have the demand from their customers to justify holding this inventory. However, they hold these products because their competition does, and it’s therefore widely accepted as a prerequisite to being a supplier within a given market. Start first with identifying those slow moving items your company must carry that represent a strategic market value, versus those items you don’t have to carry.
- Quantify Business Value of Slow Moving Inventory
While there may be a market value to holding these slow moving products, there can also be a customer or account value to holding these finished goods. Your company may have special accounts that insist on purchasing these products from your company. It could be a position of convenience, or one of loyalty. A portion of your slow moving inventory may be strategic from a business and customer account perspective. If this is the case, make sure to account for this as part of your inventory evaluation.
The above video explains carrying charges and lost sales, the two most important inventory cost drivers. To learn more, please read: Inventory Carrying Costs vs. Lost Sales: Both Destroy Your Bottom Line
- Adopt Plans for the Future
Once you’ve accounted for those products that represent a market and customer value to your company, you should now be left with a number of ancillary products that simply don’t add any value at all. The causes of these slow movers could range from inaccurate sales forecasts, improper product and market introductions, or even overstocking. Whatever the cause, these products must be dealt with accordingly. So, how is this done?
- Move These Product Lines to “Build-to-Order” Status
The best way to reduce the costs of holding inventory, is to not hold that inventory. In this case, those products that represent neither a market, or customer value, should immediately be moved to “build-to-order” status. This implies that your company doesn’t hold the inventory and your customers must adopt established lead times within their order patterns. If you’re concerned about this approach, consider the time it takes to sell this inventory relative to the costs of holding it over time.
Not only can the 80/20 Pareto rule be applied to inventory management, it can also be applied throughout a company’s entire operations. When it’s applied to inventory, companies often gain tremendous insight into what product lines are their fast movers versus those product lines that are simply too costly to carry.
Make it a point to use the rule to identify your company’s slowest moving products. Next, account for those product lines that represent a critical market and customer value relative to those your company simply shouldn’t carry. Finally, establish a plan to eliminate the costs of holding this inventory for long periods. Every single day you hold less inventory is another day where your company has reduced its carrying charges. In the end, every product's success or failure should be measured by how long it's held in inventory.
To see the rule applied in Marketing, please go here.
To use the rule to lower your company's costs of freight, please go here.
The rule can also be applied to track the causes of high cycle times in manufacturing. To learn more please go here.
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