What Is the 80/20 Inventory Rule?

Blog Credit: Abby Jenkins , April 19, 2021 (What Is the 80/20 Inventory Rule? | NetSuite)

What products deliver the most profitability? Are they the same as your top sellers, or are you moving a high volume of pricey-to-produce items while skimping on marketing for SKUs that yield healthier margins?

The 80/20 inventory rule can provide insights on all counts and help you better manage your product 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 up working capital, lower borrowing costs and increase cash flow.

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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 unit of 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 emphasize them over slower sellers, and you’ll increase sales. If you further sort to favor higher-margin products within that 20%, you optimize your inventory for both volume and profitability.

Businesses that roll with the 80/20 inventory rule can increase their working capital, better align products with customer demand and fine-tune their inventory planning strategies to ensure they never run out of any high-margin product.

The 80/20 rule is also known as the Pareto Principle, named after Italian economist Vilfredo Pareto. In 1906, Pareto realized that 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 be applicable 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 that generate the bulk of your sales and profits. With a modern enterprise resource planning (ERP) dashboard and the right supply chain metrics and KPIs, this information is just a few calculations away. For these products, it’s critical 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 — those between, say, the top 20% and the bottom 30%. For these midrange offerings, explore how to make them more appealing and/or highly profitable.

Some companies regularly identify and sunset their worst performers to free up resources to add new SKUs or services. Others attempt to remediate, adjusting their inventory and supply chain relationships to cut costs while looking at whether these poor performers could benefit from an investment in marketing.

By regularly applying the 80/20 concept to your product and services set, you can rationalize your 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 Joseph Juran who popularized the concept in a business context in the 1940s. Juran, who also expressed the rule as “the vital few and the trivial many,” left a significant body of work and an eponymous consultancy geared to helping companies realize continuous quality improvements.

Today the rule is used in many contexts: Some businesses find that 20% of customers provide 80% 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 where the principle has proven true.

The 80/20 inventory rule is a newer concept, but its value to any product-driven business cannot be understated. Some businesses may see small gains from focusing on the 80/20 inventory 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 rule is based on statistical analysis, which gives decision-makers a repeatable, verifiable way to manage inventory. Rather than following the marketing team’s instincts or reactively rushing to keep up with customer demand, the 80/20 inventory rule provides a framework to plan 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 as the vital 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 obscures up-and-coming products that not have yet broken into the top 20% of performers — but that have potential. This is where trend reports are invaluable: Companies with modern ERP systems can add context to show which midrange products or services are steadily increasing in 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 that inspire outsize customer loyalty. That is, don’t assume that the bottom 20% or 30% of items are expendable.

An 80/20 strategy can be very helpful in inventory management. But it should be used in a balanced way to ensure your customer base stays happy and your business continues 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 are costly inventory, so Toyota doesn’t want too many units sitting on lots getting dusty. But it also wants to have vehicles with popular combinations of options on hand so that customers can drive away with brand-new cars immediately if they wish.

Toyota’s inventory system follows the 80/20 inventory rule with an objective of stocking the 20% of build combinations that make up the top 80% of sales for each market. It further encourages customers to choose from that top list of performing vehicles by advertising and promoting those profitable models.

Lessons for all companies include adding geographic context and coordinating inventory management 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 the right software and tools, getting started is a straightforward process.

Implement inventory management software: If don’t already have an inventory management system that can provide the necessary insights, start by choosing specialized software or investigating whether your ERP provider offers inventory management modules. That can be a more effective route versus a standalone inventory management system because you can more easily incorporate financial and other data in reports.

Identify your top 20% best-selling and most profitable products: Note that while there is likely to be overlap, these two lists may not align exactly. Then, using your inventory or ERP system, generate a list of products that generate both high sales volumes and strong profits. It’s a combination of the two that make a successful product. And, as discussed, 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 is the purview of inventory control, also called stock control, specialists who make sure the right type and amount of supplies 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 need additional marketing, while very profitable products outside the 20% may be in line for more investment versus less profitable items. Think about which offerings in the bottom 20% could be discontinued without affecting customer satisfaction.

Monitor and iterate: The 80/20 inventory rule isn’t a set-it-and-forget-it system. Continuously monitor the performance of top products and analyze that collected data to improve your practices over time. Consider bringing in inventory forecasting experts, especially when supply chains and consumer demand are changing rapidly. These specialists focus on statistical data analysis and can predict which products could bubble up into the top level.

How to Classify Inventory

Your inventory can be broken down in a variety of ways. Companies should evaluate various inventory models and settle on a system that works for them. Most businesses can break their inventory 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 make processed foods.

Work in progress: WIP are goods that are in progress but not yet ready to sell, such as sheets of glass, window frames, fabric or flour.

Finished goods: Finished goods are ready-to-sell items, such as a window, suit coat or loaf of bread. Finished goods may be either intermediate items headed for another manufacturer, such as fabric to a clothing maker or bread to a sandwich shop, or a consumer good destined for a retailer or direct-to-consumer (D2C) sale.

Maintenance, repair and operations: MRO items are items needed to keep the production line up and running, like tools or spare parts, or consumables to get products to their destinations, like paint or packaging. Some businesses may only operate in one of those areas, while some manufacturers require all four inventory types. Your inventory management software should help you manage inventory by type with detailed tracking, cost, sourcing and other information all in one place.

How to Categorize Inventory

Within your inventory classes, you can add additional groupings. Some businesses use simplistic high-value and low-value categories, but those using the 80/20 inventory rule can take 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 analysis technique, which determines value based on a SKU’s importance to the business based on 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 SKUs that sell poorly, you minimize the amount of stock that sits in your warehouses. And, carrying costs tie up valuable cash. Lowering your holding period, and thus costs, can free up capital for investment.

Again, the best way to track your savings is with a modern ERP that includes an inventory management module. Even companies with complex operations and just-in-time inventory models can get detailed information when using the right system.

Inventory professionals have plenty of challenges to deal with 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 analysis that shows what goods or services earn the most profits. But don’t stop there. Once you start looking through the 80/20 lens, you will find more places where it’s applicable for your business.

For example, it’s a tenet of services firms that, for better or worse, 80% of business comes from 20% of customers. On the “better” side of that ledger, those bottom 80% of clients represent an opportunity to increase customer lifetime value. However, if you run a consultancy and 20% of customers consume the bulk of your advisers’ billable hours, some of them are likely costing you money, and it may be time to look at a core set of KPIs that will yield insights for services firms.

The fact is, not all customers are created equal.

Taking Charge of Your Inventory With Inventory Management Software

Your inventory won’t manage itself, and working without complete and up-to-date data can lead to costly mistakes. That makes an investment in inventory management software a good bet for any company that lacks insights into the profitability of individual 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 and finance data from a central database.

If you’ve never looked at your accounting records or inventory with an eye to the Pareto Principle, there’s no better time to give it a try than today.