10 The ‘Pareto’ or 80/20 rule

Fig. 2.10 The ‘Pareto’ or 80/20 rule

The appropriate measure should be profit rather than sales revenue or volume. The reason for this is that revenue and volume measures might disguise considerable variation in costs. In the case of customers this cost is the ‘cost to serve’ and we will later suggest an approach to measuring customer profitability. In the case of product profitability we must also

be careful that we are identifying the appropriate service-related costs as they differ by product. One of the problems here is that conventional accounting methods do not help in the identification of these costs.

What we should be concerned to do at this stage in the analysis is to identify the contribution to profit that each product (at the individual stock keeping unit (SKU) level) makes. By contribution we mean the difference between total revenue accruing and the directly attributable costs that attach as the product moves through the logistics system.

Looking first at differences in product profitability, what use might

be made of the A,B,C categorization? Firstly it can be used as the basis for classic inventory control whereby the highest level of service (as represented by safety stock) is provided for the ‘A’ products, a slightly lower level for the ‘B’ products and lower still for the ‘Cs’. Thus we might seek to follow the stock holding policy shown below:

2 L O G I S T I C S A N D C U S T O M E R VA L U E

Product category Stock availability

A 99%

B 97%

C 90% Alternatively, and probably to be preferred, we might differentiate the

stock holding by holding the ‘A’ items as close as possible to the cus- tomer and the ‘B’ and ‘C’ items further up the supply chain. The savings in stock holding costs achieved by consolidating the ‘B’ and ‘C’ items as a result of holding them at fewer locations would normally cover the additional cost of despatching them to the customer by a faster means of transportation (e.g. overnight delivery).

Perhaps the best way to manage product service levels is to take into account both the profit contribution and the individual product demand. We can bring both these measures together in the form of a simple matrix in Figure 2.11. The matrix can be explained as follows.

Quadrant 1: Seek cost reductions

Because these products have high volume it would suggest that they are in frequent demand. However, they are also low in profit contribution and the priority should be to re-examine product and logistics costs to see if there is any scope for enhancing profit.

Quadrant 2: Provide high availability

These products are frequently demanded and they are more profitable. We should offer the highest level of service on these items by holding them as close to the customer as possible and with high availability. Because there will be relatively few of these items we can afford to follow such a strategy.

Quadrant 3: Review

Products in this category should be regularly appraised with a view to deletion from the range. They do not contribute to profits (or at least only marginally) and they are slow movers from a sales point of view. Unless they play a strategic role in the product portfolio of the firm then there is probably a strong case for dropping them.

Seek cost Provide high High

reduction availability

olume (by SKU) (3) (4) V Review

Centralized Low

inventory

Low

High Profit contribution (by SKU)