People throw out the 80/20 rule but really don't know what it means and how to use it. To understand the 80/20 rule we need a bit of history:
Vilfredo Federico Damaso Pareto (born Wilfried Fritz Pareto; 15 July 1848 – 19 August 1923) was an Italian engineer, sociologist, economist, political scientist, and philosopher. He made several important contributions to economics, particularly in the study of income distribution and in the analysis of individuals' choices. He was also responsible for popularising the use of the term "elite" in social analysis.
He introduced the concept of Pareto efficiency and helped develop the field of microeconomics. He was also the first to discover that income follows a Pareto distribution, which is a power law probability distribution. The Pareto principle was named after him and built on observations of his such as that 80% of the land in Italy was owned by 20% of the population.
He further observed that this was a repetative phenomenon that a small percentage of the total population controls most of the wealth, regardless of the country studied. This same priciple holds true regardless of the nature of the population. We refer to it today as the ABC Analysis or distribution by value.
Pareto's law states that for any given group, a small number of items in the group will account for the bulk of the total value. In other words, about 20% of the various makes of cars produced will account for 80% of the total sales; 20% of the items in the family budget account for 80% of the total dollar expenditures. This is such a useful concept that large corporations apply this principle to inventory control, production control, quality control, supply management, and many other management problems. Even though this is one of the most effective and applicable principles, it is the least exploited of basic business principles by the small to mid sized businesses regardles of their product or service.
Only talking 80/20 really isn't looking at the whole picture. We are missing a few numbers here, so let me flesh out the chart before we move on to why this is important to you.
A items – The important class | 15% - 20% in this group represent 75% - 80% of the total value |
B items – The second important class | 30% - 40% in this group represent only 15% of the total value |
C items – The last and least important group | 40% - 50% in this group represent only 5% of the total value |
Now let us be clear right from the start. Nothing breaks down in those exact numbers. But the analysis will show that the values are well within the ranges stated.
So what does this all mean to me?
For one it means that approximately half of your customers or contracts only generate 5% of your total income and the other half generates 95% of your income with 20% doing the heavy lifting (80%).
So if I get rid of the dead wood, then all my problems are solved right? Nope! Remember this works on the total population. Lose a C class customer or contract then the lowest B class customer or contract slips into the C group. Add a C class prospect and the highest C becomes a B and so on. Depending where in the group and into which group you make the addition or subtraction will result in the overall shift of one or more of the groups.
If the population is static, in other words no new members are added or subtracted, the mix will change based on each individual members contribution to the whole. For example a C class member who generates more income then previously could become an A class member. Conversely a A class member who generates in a set period all of a sudden less income will then exchange places with either a B class or C class member.
So here is how to use this information.
Put the greatest amount of effort or service to the A class members in order to maintain or increase the revenue of that group.
Spend less effort on the other two groups but do not neglect them since increasing their revnue should be the objective so as to move them up in their ranking.
Look to increase the size of your propulation especially adding members to the A and B class but remember even a C addition can improve the overall revenue picture by advancing others in the other two groups.
In inventory control, you create the strongest controls to focus on the A class which means this class needs the highest turn rates, is cycle counted the most often and is closest to the shipping door.
In vendor management, the top 20% are where 80% of your money is spent so you want to tightly control the costs generated and make sure you get the best price always.
In customer relations you want to make your best accomodations with the 20% that generate 80% of your income. But don't forget the others ie. B and C class since you want to promote them or encourage them to become B's and A's.
In overhead, 20% of your chart of accounts will make up 80% of your overhead. So look to reduce your exposure in those accounts and control them very very closely. But in your focus on those don't neglect the others and allow them to run rampant.
So when we get down to the brass tacks what this means is the greatest amount of effort should always be expended on the A catagories and because those A's are so few it is easier to control and focus on them ie. Out of 100 items we stock it is easy to only, on a frequent basis, count 20 of those to insure on hand accuracy.
To establish the classes we start by ranking each item from the greatest to the least and adding them together until they hit 80% of the total then 95% of the total and what is left is the C class.
Using this concept is only limited by your creativity so enjoy yourself in the new found control you now have.
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