Efficient business management is the key to success, starting with proper inventory management. Accurate inventory control entails knowing which items to keep stocking up and which to reduce to maximize revenue.
There are several inventory management rules, but the most important is the 80/20 inventory rule for merchandising. You can also master the key inventory rule for efficient business management, gaining an advantage over your competitors.
What is Inventory Rule 80/20?
An Italian economist, Vilfredo Pareto, created a theory of predictable imbalance that’s now applied to every area of life. His idea came from observing landownership in England, where 80% of the land belonged to 20% of the population.
Therefore, according to the 80/20 rule, or the Pareto Principle, 80% of results come from 20% of causes. As a business owner, you must identify and prioritize 20% of the factors that produce the highest results.
When applied to inventory, the Pareto principle suggests that 80% of business profits come from 20% of its inventory. Therefore, the 80/20 inventory rule allows you to better align your inventroy with customer demand, increasing sales volume, profitability, and working capital.
Remember – the rule is 80/20, but it’s not set in stone. The idea is for a business to focus its efforts on maximizing their top products. In some companies, it’s 70/30, and in others, 90/10.
How to Break Down Inventory
Various business models have different inventory types. Retailers have only one, a finished product. On the other hand, manufacturers have four. These are the four most common inventory types:
Raw Materials
Direct and indirect raw materials are one category of the manufacturer’s inventory to create products.
Direct materials – These are the materials of ingredients that form part of the final product. A furniture manufacturer will need wood, whereas a bakery needs eggs.
Indirect materials – Anything used to create the final product is an indirect material. For the furniture maker, examples include glue and nails. For the baker, it’s oil and yeast.
Work in Progress (WIP) – These goods need further modification before leaving the manufacturers. These include fabric, window frames, etc.
Finished Products – At this stage, the inventory has items ready to sell to consumers or another business for further manufacturing.
Maintenance, repair, and operations (MRO) – Tools, spare parts, equipment, these are the items that keep your business functioning.
Categorizing Your Inventory
Categorizing inventory entails ranking items under the 80/20 rule, helping you identify your top-selling items. These items are prioritized in ordering and inventory management, and the rest are managed more conservatively.
An ABC inventory is the most popular way to categorize products based on their value and profit to your business:
A Products: These are the top 20% of your products, resulting in 70% of sales
B Products: These form about 30% of your products, resulting in 20% of sales
C Products: These include the bottom 50% of your products, resulting in 10% of sales
Using the ABC rule helps refine your operational processes like reordering, lead time, and maintaining safety stocks, allowing you to control your working capital costs and improve your inventory turnover rate.
Read more about remaining productive from this informative 80/20 inventory rule article by Deskera.
Remember: A tailored approach is required for each business. For example, seasonal adjustments are necessary depending on seasonal trends.
Pros and Cons of the 80/20 Inventory Control Rule
The 80/20 inventory rule has both benefits and downsides for inventory management:
Pros of the 80/20 Inventory Rule
The statistical analysis gives you the metric for the inventory rule, meaning you have a predictable and verified tool to control your inventory. Therefore, knowing which products increase profitability is the most significant benefit, allowing you to spend more resources there.
That means keeping more stock of these items, training your staff on their sale, and optimizing your marketing efforts to your biggest customers.
Moreover, once you know which products sell the least, you can order less or remove them entirely from your inventory.
Cons of the 80/20 Inventory Rule
Since the inventory rule forms part of a general observation, it cannot always be accurate because the split can vary. Additionally, there is a danger in only concentrating on 20% of your inventory while ignoring the rest.
Ultimately, using the rule with ABC categorizing is best to increase the number of items in your “A” list. The more products on your list, the more you reduce the risk of relying on profitability from only a tiny part of your inventory.
Remember: Your 80/20 inventory relies on past data, not future predictions. Circumstances change, so keep your ears on the ground to keep up with changes. You must apply your sales team’s insights and trend reports to your strategy and listen to customer needs in your future planning.
How to Apply the 80/20 Inventory Management Rule Efficiently
The inventory rule is a simple yet effective way to maintain consistent inventory levels. The following tips will help you implement the process correctly:
Create an Inventory Management System to Identify best-selling and Slow-Moving Items
First, you need an inventory management tool that provides insights like stock levels, the cost of goods sold, and stock sales performances. The data will help you identify which items form the top 20% of your inventory.
These systems also provide actionable data that includes:
- High-value, slow-selling products that earn the most profit, which you must always have in stock.
- Low-value but fast-selling products must make up more of your inventory.
- Low-value items that are hard to sell indicate that you should reduce their stock or remove them from your inventory.
Re-evaluate Your Inventory Regularly
It would help if you remained on top of your inventory management by regular re-evaluation. Make a point of following changes to product demand and make the appropriate adjustments.
Improve Your Customer Service
Customer service can help you make the 80/20 inventory tool work better. Satisfied customers are more likely to come back for more products. An efficient ordering process based on accurate data ensures you have enough stocks to meet demand. Customer service also depends on providing accurate product information and implementing a good returns policy.
Scrutinize Your Pricing Strategy
Finally, always compare the pricing of your products with that of your competitors to ensure your inventory works correctly for you. Adjust your prices if you are under or over-pricing a product.
Real-world Applications of the 80/20 Rule
Examples and Scenarios: It’s one thing to understand a concept and another to see it in action. Consider a retail clothing store. They might find that 80% of their profits come from just 20% of their inventory – perhaps high-end designer pieces or seasonal best-sellers. In contrast, a tech wholesaler may discover that a specific brand or product type contributes significantly to their sales. By identifying these top performers, businesses can strategize their inventory purchases and marketing efforts more effectively.
Embracing the Digital Era
Technology and Modern Solutions: In today’s digitized world, businesses are spoiled for choice with advanced inventory management systems. Platforms like Shopify, QuickBooks Commerce, and Ordoro have features allowing real-time tracking, sales forecasting, and even applying the 80/20 rule automatically. These tools provide detailed analytics, helping businesses identify top-performing products and streamline inventory processes accordingly.
Navigating External Challenges
External Factors Influencing Inventory: Inventory management doesn’t operate in a vacuum. Factors like international trade wars, pandemics, or regional conflicts can cause supply chain disruptions. An economic downturn might shift consumer purchasing habits. While the 80/20 rule provides a robust guideline, businesses must remain agile, adjusting their inventory strategies in response to these larger external challenges.
Beware of Common Pitfalls
Potential Missteps: Implementing the 80/20 rule isn’t without its challenges. One common mistake is neglecting the ‘80%’ of products that bring in 20% of profits. These products often cater to niche markets and can be crucial for brand loyalty and long-term growth. Another pitfall is becoming too rigid, adhering strictly to the rule without considering seasonal fluctuations or emerging market trends. Successful implementation requires a balance of data-driven insights and adaptive strategy.
Tips for Implementing the 80/20 Inventory Rule Effectively
- Utilize Automation: Leveraging automation in your inventory management system can be a game-changer. Automated systems can track your top 20% of products and ensure they are always in stock, enhancing efficiency and reducing human error.
- Regularly Analyze Your Data: The 80/20 rule is dynamic and may change. Regularly analyzing your sales data will help identify any shifts in the popularity of your products and enable you to adjust your inventory accordingly.
- Inventory Optimization: Use the 80/20 rule to optimize your inventory. Keep your ‘A’ products readily available but don’t neglect your ‘B’ and ‘C’ products. They may not contribute significantly to your sales, but a balanced inventory ensures you cater to a wide range of customer needs.
- Adapt to Market Trends: Stay updated and adapt your inventory accordingly. Your top-selling items today may not necessarily be top-selling items tomorrow. By keeping tabs on trends, you can anticipate shifts in consumer behavior and adjust your inventory to cater to changing demands.
- Invest in Training: Train your staff on the importance of the 80/20 rule and how to implement it effectively. Well-informed employees can contribute to efficient inventory management.
Final Take
When you master the key inventory rule for efficient business management, you ensure reduced costs and improved profits. The theory of predictable imbalance applies to several other areas in your business, like 20% of employees create 80% of sales. Likewise, it suggests that 20% of customers generate 80% of profits; the same applies to your marketing efforts.
What is the 80/20 Inventory Rule?
The 80/20 inventory rule suggests that 80% of your profits come from 20% of your products. This rule helps businesses focus their resources on the most profitable items, streamline inventory management, and control costs.
What are the drawbacks of the 80/20 Inventory Rule?
The limitations of the 80/20 inventory rule include the risk of focusing too much on the top 20% of products and neglecting the rest of the inventory. Also, it relies on past data and doesn’t predict future trends or market changes.
How can I effectively apply the 80/20 Inventory Rule?
To apply the 80/20 inventory rule effectively, create an inventory management system, regularly re-evaluate your inventory, enhance your customer service, and scrutinize your pricing strategy. Regularly analyzing your data and staying updated with market trends is also crucial.
How can automation help in implementing the 80/20 Inventory Rule?
Automation can significantly enhance the implementation of the 80/20 rule by tracking your top 20% of products and ensuring they are always in stock. This enhances efficiency and reduces chances of human error.
How does the 80/20 Inventory Rule relate to ABC categorization?
ABC categorization divides inventory into three categories: A, B, and C, based on their importance. The 80/20 rule can help increase the number of items in your “A” list, reducing the risk of relying on profitability from only a tiny part of your inventory.
How does the 80/20 Inventory Rule impact customer service?
By ensuring that the most demanded products are always in stock, the 80/20 rule can lead to improved customer satisfaction. Satisfied customers are more likely to return, increasing your sales.
How do market trends affect the 80/20 Inventory Rule?
Market trends can significantly impact the 80/20 rule as the top-selling items can change over time. Staying updated with market trends allows businesses to adapt their inventory to changing demands.
