If you ask professionals about the Pareto distribution, few experts will pause to think even for a couple of seconds. The magical 80/20 ratio immediately comes to mind. The rule is applied in various ways. I like: “20% of efforts give 80% of the result” or “20% of the assortment generates 80% of sales,” “80% of success depends on 20% of efforts,” etc. I tried to use the Pareto rule and ABC analysis to figure out how these tools can be used in inventory management, and here’s what I came up with.
Suppose you run a trading company. There are about 1,000 items constantly in your assortment. If you analyze sales of the assortment by share in turnover and share in markup, you get an ABCXYZ analysis or a matrix consisting of 9 cells.
| Turnover/Markup | X | Y | Z | % |
| А | AX | AY | AZ | 80% |
| B | BX | BY | BZ | 15% |
| C | CX | CY | CZ | 5% |
| % | 80% | 15% | 5% | 100% |
Table 1
Applying the Pareto rule, you can assume that category A assortment provides 80% of sales, category B – 15%, and category C – 5%, respectively. Similarly, category X assortment accounts for 80% of markup, Y – 15%, and Z – 5%, respectively. It is interesting to see how much sales and markup each of the 9 matrix cells generates. A simple calculation shows the following:
| X | Y | Z | ||
| А | AX=64% | AY=12% | AZ=4% | 80% |
| B | BX=12% | BY=2.25% | BZ=0.75% | 15% |
| C | CX=4% | CY=0.75% | CZ=0.25% | 5% |
| 80% | 15% | 5% |
Table 2
So, it turns out that, for example, the assortment in category AX provides 64% of sales and 64% of the margin. Of course, it would be too bold to assume that the assortment giving 64% of sales exactly coincides with the assortment giving 64% of the margin—most likely, there are a number of SKUs that ended up in category A but not in category X, and vice versa. Still, the overlap is usually quite significant. At this point, this is not so important.
How many SKUs will fall into each cell of the analysis matrix? What assortment width can achieve 64% of sales and margin? Or, how many items fall into the AX cell?
According to Pareto’s rule, 20% of the assortment should provide 80% of sales. That is, category A of the assortment corresponds to 20% of the range, or 200 SKUs. So, how many will fall into categories B and C, or how many items will provide the margin in categories X, Y, or Z? It is logical to assume that categories B and C together account for the remaining assortment, or 800 SKUs. But in what proportion? To calculate this, we can use the Golden Ratio principle. To refresh your memory without causing strain:
“The Golden Ratio (golden proportion, division into extreme and mean ratio) — division of a value (for example, the length of a segment) into two parts in such a way that the ratio of the larger part to the smaller is equal to the ratio of the whole value to its larger part.
The approximate value of the golden ratio is 1.6180339887” source: Wikipedia.
Thus, we get the following distribution for the number of SKUs:
| X | Y | Z | ||
| А | AX | AY | AZ | 20% |
| B | BX | BY | BZ | 30% |
| C | CX | CY | CZ | 50% |
| 20% | 30% | 50% |
Table 3
or:
| X | Y | Z | ||
| А | AX=4% | AY=6% | AZ=10% | 20% |
| B | BX=6% | BY=9% | BZ=15% | 30% |
| C | CX=10% | CY=15% | CZ=25% | 50% |
| 20% | 30% | 50% |
Table 4
| X | Y | Z | ||
| А | AX=40 | AY=60 | AZ=100 | 20% |
| B | BX=60 | BY=90 | BZ=150 | 30% |
| C | CX=100 | CY=150 | CZ=250 | 50% |
| 20% | 30% | 50% |
Table 5
So, it turns out that only 4% of the assortment, or in our example 40 items, should account for 64% of sales and 64% of profit margin? And 25% of the assortment in CZ, or 250 items, generate only 0.25% of sales?
That’s interesting. So, if you manage the assortment properly, the out-of-stock (OOS) of a few items in the AX category could lead to disaster, while even significant OOS in the CZ category could go unnoticed. In our example, an OOS of one AX item could cost us up to 1.6% in lost sales, while the OOS of one item in CZ would result in losses of about 0.001%—1,600 times less.
Using the above logic, we can move on to the patterns that must be considered in inventory management. The ideal scenario is when the majority of stock is found in the assortment generating most of the turnover, and stocks of items that do not provide significant sales are minimized. So, if we assume that sales are distributed as in Table 2, then stocks should be distributed similarly.
| Inventory | X | Y | Z | % |
| А | AX=64% | AY=12% | AZ=4% | 80% |
| B | BX=12% | BY=2.25% | BZ=0.75% | 15% |
| C | CX=4% | CY=0.75% | CZ=0.25% | 5% |
| % | 80% | 15% | 5% | 100% |
Table 6
The assortment in category AX should account for 64% of the inventory. If the goal is to achieve an inventory turnover of 12 times a year, or in other words, to maintain stock at the level of one month’s sales, then the stock for each category should match the sales in those categories. There is nothing stopping you from adjusting the algorithm to maintain inventory at a turnover rate of 24, or at a stock level equivalent to two weeks of sales. Here, the question concerns planograms, minimum supply batches, and their frequency.
For example, if 1,000 assortment items generate 10,000 UAH in sales, and the inventory turnover is 12, the average monthly inventory will be 10,000 UAH, of which:
| Inventory UAH. | X | Y | Z | % |
| А | AX=6400 | AY=1200 | AZ=400 | 80% |
| B | BX=1200 | BY=225 | BZ=75 | 15% |
| C | CX=400 | CY=75 | CZ=25 | 5% |
| % | 80% | 15% | 5% | 100% |
Table 7
How should attention be allocated in inventory management? As you may have guessed, once again according to the Pareto rule. 80% of your attention should be devoted to the 20% of the assortment that generates 80% of sales, and only 20% of your attention (time) can be spent on the remaining 80% of the assortment, which generates just 20% of sales (similar to Table 6). Think about it—usually, everything is done exactly the opposite.
Let’s try to imagine that we don’t see any difference in the assortment we work with and strive to manage each item we sell equally attentively and meticulously. It sounds reasonable, but let’s compare the numbers. For example, let’s assume that managing an assortment item with the highest quality requires spending 5 minutes per week. In that case, managing the entire assortment would require 5,000 minutes of work time, or 83 hours, or 2 specialists—assuming the same level of productivity throughout all 8 hours of the workday. If we apply the principle of allocating attention according to the importance of each assortment item, then the time spent on managing the entire assortment will decrease. For 200 items in category A, specialists will spend 1,000 minutes of their time, and on the remaining 800—only 250 minutes, or a total of 1,250 minutes, which equals 21 hours or the work of 1 specialist at half-time. That is, four times less. Of course, this calculation is suitable for a homogeneous assortment (within one category), but the benefit is obvious. It’s worth the effort!
By consistently applying this logic, over time, you can align inventory with sales and assortment, which will allow you to manage inventory turnover, minimize losses from OOS, minimize funds frozen in illiquid stock, and consequently increase sales and profit.
It’s hard to even imagine how much work time is freed up! 🙂
Filianin S.N.
04.2013