Which products bring in the most profit? Businesses that apply the 80/20 inventory rule can increase working capital, better align products with customer demand and refine their inventory planning strategy to ensure they never run out of any highly profitable product.
In this article we will look at some great tips. By the time you finish reading this article, you will have learned:
What the 80/20 inventory management rule is;
How to apply this rule; and
The best tools for optimizing inventory management.
Contents
1. What is the 80/20 inventory management rule?
2. Advantages of the 80/20 rule
3. Disadvantages of the 80/20 inventory management rule
5. How to apply the 80/20 inventory management rule
7. How to classify inventory categories
8. Is the 80/20 rule right for your business?
What is the 80/20 inventory management rule?
The 80/20 rule says that 80% of results come from 20% of efforts, customers or another unit of measure. Applied to inventory, the rule suggests that companies earn about 80% of their profit from 20% of their products. If you further prioritize the higher-margin products within that 20%, you will optimize your inventory in terms of both volume and profit.
Businesses that apply the 80/20 inventory rule can increase working capital, better align products with customer demand and refine their inventory planning strategy to ensure they never run out of any highly profitable product.
The 80/20 inventory rule comes from a theory known as the Pareto principle.
The Pareto principle, named after the economist Vilfredo Pareto, is an observation (not a law) developed by Joseph M. Juran, who stated that in any quality control or improvement activity, only 20% of the effort expended contributes to 80% of the output.
The Pareto principle is a general rule you can apply to every area of your business, for example:
· Production - 20% of your production processes account for 80% of finished goods;
· Management - 20% of your plans account for 80% of your scheduling; and
· Human resources - 20% of your workforce accounts for 80% of the work completed.
In the context of inventory management, the first step is to identify the 20% of products that generate most of your sales and profit. 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 is important to watch the inventory flow and always keep the shelves stocked.
Advantages of the 80/20 rule
The main benefit of the 80/20 inventory rule is the ability to reduce inventory carrying costs, the costs of holding inventory until it is sold. When you eliminate poorly selling SKUs, you minimize the amount of dead stock in your warehouse. And carrying costs tie up valuable cash. Reducing your holding time, and therefore costs, can free up capital for investment.
The 80/20 inventory rule is based on statistical analysis, giving decision-makers a repeatable, verifiable way to manage inventory. Instead of following the marketing team's instincts or reacting hastily to keep up with customer demand, the 80/20 rule provides a framework for planning ahead while reinforcing your business focus around the most profitable product lines.
Again, the best way to track your savings is to use a modern ERP system that includes an inventory management module. Even companies with complex operations and just-in-time inventory models can gain insights with the right system.
Disadvantages of the 80/20 inventory management rule
The main disadvantage of managing by the 80/20 inventory rule is that it obscures up-and-coming products that haven't yet made it into the top 20% of performers - but have potential. This is where trend reports are invaluable: companies with modern ERP systems can add context to show which mid-range products or services are steadily gaining popularity or have margins that make them worth further investment.
Companies should also reach out to sales leads for insight into less popular offerings that inspire customer loyalty. In other words, don't assume the bottom 20% or 30% of items are expendable.
The 80/20 strategy can be very useful in inventory management. But it should be used in a balanced way to ensure your customer base stays satisfied and your business keeps nurturing new products and services.
Examples of the 80/20 rule
A notable example of the 80/20 inventory rule comes from Toyota Motor Corp. Vehicles are expensive inventory, so Toyota doesn't want too many units sitting on lots gathering dust. But it also wants to have cars with popular option combinations on hand so customers can drive away in a brand-new car immediately if they want.
Toyota's inventory system follows the 80/20 inventory rule, aiming to stock the 20% of build combinations that make up 80% of top sales in each market. It further encourages customers to choose from that list of top-performing vehicles by advertising and promoting those profitable models.
The lesson for all companies is to add geographic context and coordinate inventory management with marketing and sales efforts.
How to apply the 80/20 inventory management rule
With the 80/20 inventory management rule, you are assuming that:
80% of your sales come from 20% of your inventory;
80% of your customers only want 20% of your products; and
80% of your storage space is waste, and 20% of your storage space holds the items that sell.
Inventory management with the 80/20 rule
Pro tip
Category A: the top 20% of products that generate 80% of profit
Category B: 30% of products that generate 25% of profit
Category C: 50% of products that generate 5% of profit
Focus on the 20% of best-selling, most profitable goods
To do this, you'll need to identify which products sell best, which is a relatively easy task. If you are a T-shirt manufacturer and your blue shirts are selling well, you need to make sure you always have blue shirts in stock.
Most manufacturers achieve this by looking at cost of goods sold (COGS) to pinpoint which items sell the most.
However, your items may not be that simple to analyze.
You may have many products that sell, but whose profit margin is the very lowest. Focusing on these items may not be the best strategy.
Another way to identify your 20% is to rank products by the following three categories:
· Cost of goods sold;
· Order frequency; and
· Gross profit.
A product with a low cost of goods sold that ranks well in the other two categories spends little time in inventory and is in high demand from customers. Such a product may therefore be better to focus on than a popular product with little profit.
Refresh your marketing
Now that you know your most profitable products, you can consider reducing some of the marketing effort for them. Best-selling products may not need extra marketing, while highly profitable products outside the 20% group may be better investments than less profitable items. Think about which of your lowest-ranked products or services could be discontinued without affecting customer satisfaction.
Monitor and repeat
The 80/20 inventory rule is not a set-and-forget system. Continuously monitor the performance of your top products and analyze the data collected to improve your methods over time. Consider bringing in inventory forecasting experts, especially when supply chains and consumer demand are changing rapidly. These experts focus on statistical data analysis and can predict which products may rise to the top tier.
Khám phá: The 6 best ways to manage a smart, modern warehouse and optimize performance
How to classify inventory
Your inventory can be broken down in many different ways. Companies should evaluate different inventory models and settle on a system that works for them. Most businesses can divide their inventory into four main types:
Raw materials: This category includes items such as sand, wood or wool, or raw fruit, vegetables, grains or meat used in food processing…
Work in progress (WIP): WIP is goods that are being finished but are not yet ready for sale, such as glass panes, window frames, fabric or flour.
Finished goods: Finished goods are items ready for sale, such as windows, jackets or loaves of bread. Finished goods may be intermediate items supplied to another manufacturer, such as fabric for a clothing maker or bread for a bakery, or a consumer item for a retailer or sold directly to consumers (D2C).
Maintenance, repair and operations: MRO items are the items needed to keep a production line running, such as tools or spare parts, or consumables used to get products to their destination, like paint or packaging. Some businesses may operate in only one of these areas, while some manufacturers need all four types of inventory.
Learn more: Warehouse management system features each industry needs
How to classify inventory categories
Within your inventory classes, you can add extra groups. Some businesses use high-value and low-value categories, but businesses that use the 80/20 inventory rule can take a more creative approach.
Consider setting your categories to reflect product profitability before other factors. For example, when you roll out your new 80/20 system, you may also want to use ABC analysis, which determines value based on how important a SKU is to the business according to criteria such as customer demand and cost KPIs.
ABC analysis is an inventory control model based on the 80/20 rule (the Pareto principle applied to inventory). It has three categories, A, B and C, to help you prioritize further and classify accurately.
Category A - These products bring in 80% of your profit. Although they make up only 20% of your stock and don't sell as often or as consistently as others, they need the most attention.
Category B - Items that contribute up to 25% of revenue and have good margins but are not critical to your business. They sell very well, though, so keep them at 30% of your stock.
Category C - Although these aren't high-value items and generate only 5% of your profit, they still sell consistently. These items will make up about 50% of your stock and don't require close monitoring.
For example, if you sell pet bedding and pet sofas, your products are currently in demand. Your most profitable products (Category A) are the $1,200 sofas, which sell on average twice a week. Your $70 pet beds (Category B) sell on average 10 times a week. The other bedding items that sell well all fall into Category C.
ABC analysis requires careful attention and accurate data to ensure your inventory is classified correctly and leads to profit rather than loss. An inventory control system can help.
Is the 80/20 rule right for your business?
Although not every company holds inventory, almost any business can benefit from analysis showing which goods or services earn the most profit. But don't stop there. Once you start looking through the 80/20 lens, you'll find more areas where it applies to your business.
For example, the principle for service companies, for better or worse, is that 80% of business comes from 20% of clients. The remaining 80% of clients may offer opportunities to increase customer lifetime value. However, if you run a consulting firm and 20% of clients use most of your consultants' billable hours, some of them may be losing you money, and it may be time to look at the core set of KPIs that give insight into service companies.
The fact is, not all customers are created equal.
Conclusion
Your inventory won't manage itself, and operating without complete, up-to-date data - and that can lead to costly mistakes. That makes investing in inventory management software a good bet for any company lacking deep insight into the profitability of individual products.
If you have never looked at your inventory through the lens of the Pareto principle, there's no better time to try it than today.
Learn more about how SmartBiz smart warehouse management works to automate inventory management, increase accuracy, improve performance, reduce costs and increase cash flow.