What products deliver the most profitability? Are they the same as your top sellers, or areyou moving a high volume of pricey-to-produce items while skimping on marketing for SKUsthat yield healthier margins?
The 80/20 inventory rule can provide insights on all counts and help you better manage yourproduct lineup to optimize your balance sheet while potentially increasing profits.Companies that dive deep into the metrics that feed into 80/20 calculations can free upworking capital, lower borrowing costs and increase cash flow.
What Is the 80/20 Inventory Management Rule?
The 80/20 rule states that 80% of results come from 20% of efforts, customers or another unitof measurement. When applied to inventory, the rule suggests that companies earn roughly 80%of their profits from 20% of their products. Identify those top performers and emphasizethem over slower sellers, and you’ll increase sales. If you further sort to favorhigher-margin products within that 20%, you optimize your inventory for both volume andprofitability.
Businesses that roll with the 80/20 inventory rule can increase their working capital, betteralign products with customer demand and fine-tune their inventoryplanning strategies to ensure they never run out of any high-margin product.
The 80/20 rule is also known as the ParetoPrinciple, named after Italian economist Vilfredo Pareto. In 1906, Pareto realizedthat 80% of Italy’s land was owned by 20% of the population.
His observation that roughly 80% of effects come from 20% of causes turned out to beapplicable across a wide range of situations, from gardening to finance.
In context of inventory management, the first step is to identify the 20% of products thatgenerate the bulk of your sales and profits. With a modern enterprise resource planning(ERP) dashboard and the right supply chain metrics andKPIs, this information is just a few calculations away. For these products,it’scritical to pay attention to inventory flows and always keep the shelves stocked.
For the remaining 80% of products or services, break down your midlevel performers —thosebetween, say, the top 20% and the bottom 30%. For these midrange offerings, explore how tomake them more appealing and/or highly profitable.
Some companies regularly identify and sunset their worst performers to free up resources toadd new SKUs or services. Others attempt to remediate, adjusting their inventory and supplychain relationships to cut costs while looking at whether these poor performers couldbenefit from an investment in marketing.
By regularly applying the 80/20 concept to your product and services set, you can rationalizeyour total inventory as you wind down lines that generate neither sales nor healthy profits.
History of the 80/20 Inventory Rule
While Pareto pioneered the 80/20 phenomenon, it was engineer and management consultant JosephJuran who popularized the concept in a business context in the 1940s. Juran, who alsoexpressed the rule as “the vital few and the trivial many,” left a significantbody of workand an eponymous consultancy geared to helping companies realize continuous qualityimprovements.
Today the rule is used in many contexts: Some businesses find that 20% of customers provide80% of profits, or 20% of consultants generate 80% of billable hours. Others find that 80%of quality-control problems arise from 20% of causes. There are endless permutations wherethe principle has proven true.
The 80/20 inventory rule is a newer concept, but its value to any product-driven businesscannot be understated. Some businesses may see small gains from focusing on the 80/20inventory rule; for others, it can be a game-changer that drives new levels of success.
Advantages of the 80/20 Rule
Most CFOs appreciate data-driven methodologies to increase profits. The 80/20 inventory ruleis based on statistical analysis, which gives decision-makers a repeatable, verifiable wayto manage inventory. Rather than following the marketing team’s instincts orreactivelyrushing to keep up with customer demand, the 80/20 inventory rule provides a framework toplan ahead while consolidating your business focus around the most profitable product lines.
Finance teams looking to explain the concept might follow Juran’s lead and frame it asthevital few products and the trivial many.
Disadvantages of the 80/20 Inventory Management Rule
The main disadvantage of managing based on the 80/20 inventory rule is that it obscuresup-and-coming products that not have yet broken into the top 20% of performers — butthathave potential. This is where trend reports are invaluable: Companies with modern ERPsystems can add context to show which midrange products or services are steadily increasingin popularity or have profit margins that make them worth continued investment.
Companies should also reach out to sales leads for insights into less popular offerings thatinspire outsize customer loyalty. That is, don’t assume that the bottom 20% or 30% ofitemsare expendable.
An 80/20 strategy can be very helpful in inventory management. But itshould be used in a balanced way to ensure your customer base stays happy and your businesscontinues to nurture new products and services.
Example of the 80/20 Rule
One noteworthy example of the 80/20 inventory rule comes from Toyota Motor Corp. Vehicles arecostly inventory, so Toyota doesn’t want too many units sitting on lots getting dusty.Butit also wants to have vehicles with popular combinations of options on hand so thatcustomers can drive away with brand-new cars immediately if they wish.
Toyota’s inventory system follows the 80/20 inventory rule with an objective ofstocking the20% of build combinations that make up the top 80% of sales for each market. It furtherencourages customers to choose from that top list of performing vehicles by advertising andpromoting those profitable models.
Lessons for all companies include adding geographic context and coordinating inventorymanagement with marketing and sales efforts.
How to Implement the 80/20 Inventory Management Rule
Adopting the 80/20 inventory rule doesn’t have to be a daunting task. In fact, with therightsoftware and tools, getting started is a straightforward process.
Implement inventory management software: If don’t already have an inventory managementsystem that can provide the necessary insights, start by choosing specializedsoftware or investigating whether your ERP provider offers inventory management modules.That can be a more effective route versus a standalone inventory management system becauseyou can more easily incorporate financial and other data in reports.
Identify your top 20% best-selling and most profitable products: Note thatwhile there is likely to be overlap, these two lists may not align exactly. Then, using yourinventory or ERP system, generate a list of products that generate both high sales volumesand strong profits. It’s a combination of the two that make a successful product. And,asdiscussed, analyze which SKUs are likely to enter that upper 20% in the near future.
Analyze and optimize your inventory process: With your top 20% list in hand,start shifting your processes to optimize the match between inventory and demand. This isthe purview of inventory control, alsocalled stock control, specialists who make sure the right type and amount ofsupplies are available at the right time to meet customer demand.
Refresh your marketing: Because you now know your most profitable products,you can consider doubling-down on marketing efforts for those SKUs. Bestsellers may not needadditional marketing, while very profitable products outside the 20% may be in line for moreinvestment versus less profitable items. Think about which offerings in the bottom 20% couldbe discontinued without affecting customer satisfaction.
Monitor and iterate: The 80/20 inventory rule isn’t aset-it-and-forget-itsystem. Continuously monitor the performance of top products and analyze that collected datato improve your practices over time. Consider bringing in inventory forecastingexperts, especially when supply chains and consumer demand are changing rapidly.These specialists focus on statistical data analysis and can predict which products couldbubble up into the top level.
How to Classify Inventory
Your inventory can be broken down in a variety of ways. Companies should evaluate various inventorymodels and settle on a system that works for them. Most businesses can break theirinventory down into four main types:
4 Main Inventory Types Explained
Raw materials: This category includes both nonperishable materials,such as sand, wood or wool, or raw fruits, vegetables, grains or meats used to makeprocessed foods.
Work in progress: WIP are goods that are in progress but not yetready to sell, such as sheets of glass, window frames, fabric or flour.
Finished goods: Finished goods are ready-to-sell items, such as awindow, suit coat or loaf of bread. Finished goods may be either intermediate itemsheaded for another manufacturer, such as fabric to a clothing maker or bread to asandwich shop, or a consumer good destined for a retailer or direct-to-consumer(D2C) sale.
Maintenance, repair and operations: MRO items are items needed tokeep the production line up and running, like tools or spare parts, or consumablesto get products to their destinations, like paint or packaging. Some businesses mayonly operate in one of those areas, while some manufacturers require all fourinventory types. Your inventory management software should help you manage inventoryby type with detailed tracking, cost, sourcing and other information all in oneplace.
How to Categorize Inventory
Within your inventory classes, you can add additional groupings. Some businesses usesimplistic high-value and low-value categories, but those using the 80/20 inventory rule cantake a more innovative approach.
ABC Inventory
Consider setting your categories to align with product profitability before other factors.For example, as you implement your new 80/20 system, you may also want to use the ABC inventory analysistechnique, which determines value based on a SKU’s importance to the businessbasedon criteria such as customer demand and cost KPIs.
| Inventory Category | Profitability Range |
|---|---|
| Category A | Top 20% profitable products |
| Category B | 21st to 80th percentile |
| Category C | Bottom 20% |
Tracking Holding Costs With the 80/20 Rule
A major benefit of the 80/20 inventory rule is the ability to lower inventory carrying costs,the expenses that come with holding inventory until it’s sold. When you eliminate SKUsthatsell poorly, you minimize the amount of stock that sits in your warehouses. And, carryingcosts tie up valuable cash. Lowering your holding period, and thus costs, can free upcapital for investment.
Again, the best way to track your savings is with a modern ERP that includes an inventorymanagement module. Even companies with complex operations and just-in-time inventory modelscan get detailed information when using the right system.
Inventory professionals have plenty of challenges to dealwith daily. Gathering reliable, timely inventory data shouldn’t be one of them.
Is the 80/20 Rule Right for Your Business?
While not all companies carry inventory, nearly any business can benefit from an analysisthat shows what goods or services earn the most profits. But don’t stop there. Onceyoustart looking through the 80/20 lens, you will find more places where it’s applicableforyour business.
For example, it’s a tenet of services firms that, for better or worse, 80% of businesscomesfrom 20% of customers. On the “better” side of that ledger, those bottom 80% ofclientsrepresent an opportunity to increase customer lifetime value. However, if you run aconsultancy and 20% of customers consume the bulk of your advisers’ billable hours,some ofthem are likely costing you money, and it may be time to look at a core set of KPIs that will yield insightsfor services firms.
The fact is, not all customers are created equal.
Award Winning
Cloud Inventory
Free ProductTour
Taking Charge of Your Inventory With Inventory Management Software
Your inventory won’t manage itself, and working without complete and up-to-date datacan leadto costly mistakes. That makes an investment in inventory managementsoftware a good bet for any company that lacks insights into the profitability ofindividual products.
With Oracle NetSuite, you can handle all parts of your business from one central hub.Inventory teams will appreciate having the tools to manage the supply chain and gain insight into accounting andfinance data from a central database.
If you’ve never looked at your accounting records or inventory with an eye to theParetoPrinciple, there’s no better time to give it a try than today.
