The 80/20 inventory rule states that 80% of your profits come from 20% of your inventory. But, how do you take advantage of this information?
Last updated: 29.06.2023
If you sell 10 items, and in your storage space you can store 100 items, it almost seems laughably logical to have 10 of each item.
Unfortunately, it’s not that simple. You’ll probably notice that 20 items are always out of stock, while the remaining 80 go unnoticed.
If this is a problem that sounds familiar to you, then you’ll be glad to know that in this article, we’re going to look into a life hack: The 80/20 Inventory rule.
By the time you’ve finished reading this article, you’ll have learned:
What is the 80/20 inventory rule;
How to implement inventory rules; and
The best tools for optimizing inventory management.
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What is the 80/20 Inventory Rule?
The 80/20 inventory rule is the tactic of prioritizing the 20% of your inventory that accounts for 80% of your business’s profit.
Manufacturers usually apply this inventory rule when auditing their inventory to reduce carrying costs and lead time. But there are many more benefits to using this technique, which we will explore later.
The Pareto principle, named after economist Vilfredo Pareto, is an observation (not law) developed by Joseph M. Juran, who stated that when performing any quality control or improvement, only 20% of the effort spent contributes to 80% of the output.
The Pareto principle is a rule of thumb that you can apply to all areas of your business, such as:
Manufacturing – 20% of your production process accounts for 80% of a finished good;
Management – 20% of your planning accounts for 80% of your scheduling; and
Human Resources – 20% of your workforce accounts for 80% of the work completed.
The idea of the 80/20 inventory rules is to highlight the relationship between the number of resources that a product or process consumes and the potential ROI of these actions.
With the 80/20 inventory rule, you are supposing 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 is waste, and 20% of your storage contains items that sell.
Focusing on the 20% of Your Inventory
To do this, you’re going to need to identify what products sell consistently for you, which is a relatively easy task. If you’re a t-shirt manufacturer and your blue ones are selling like hotcakes, you need to make sure you always have blue shirts at hand.
Most manufacturers achieve this by looking at the cost of goods sold (COGS) to accurately pinpoint which items sell the most.
However, maybe your items aren’t so straightforward to analyze.
You could have products you sell a lot of, but the profit margin is some of the lowest. Focusing on these items might not be the best strategy.
Another way of identifying your 20% is to rank a product by these three categories:
Cost of goods sold;
Frequency of orders; and
A product with low COGS but ranks well in the other two categories means it spends little time tied up in inventory and is highly requested by customers.
Therefore, a product like that might be better to focus on, as opposed to one that is popular but has little profit.
Focusing on 20% of Your Products
Now you’ve identified your 20% it’s time to start making these a priority on your storefronts. You’ll want to prominently display these items and make them as convenient as possible for customers to buy because at the end of the day, this is the reason why they’re here.
You’ll find that customer satisfaction and recommendations will go through the roof if you give customers a totally hassle-free experience.
Focusing on the 20% of Your Offerings
Let’s imagine you make and sell t-shirts. Blue is once again in high demand, but for green t-shirts, you might get one order a month. If your storage capacity is 40 t-shirts, you wouldn’t store 20 blue and 20 green t-shirts, would you?
If you notice that one item in your storage is forever low on stock, while another is seemingly overflowing, it’s time to reorganize your storage space to get the most value out of your items.
And that’s how you implement 80/20 inventory rules in a nutshell. Although, we all know that anything in life is never that easy.
In principle, you know now how the inventory rule works, but how do you appropriately adopt it into your business?
Now comes the next steps in following your inventory rules to optimize your stock.
How to Classify Your Inventory?
So, you’ve applied the 80/20 inventory rule to all the items in your stock room, and you now have a better understanding of which items bring in the most profit.
But, what do you do with this information?
Now you can start to classify your inventory, reconfigure your stockroom and factory floor, and even remove items from production if you must.
Although, before you begin this task, you need to understand and categorize all your items, and there are four types of inventory your items will fall into.
Work in progress (WIP) inventory encompasses the materials that are active on your shop floor or stock that needs further modification before it’s fit for market.
Finished goods inventory is the items that are fully processed and ready to be sold.
Maintenance, Repair, and overhaul (MRO)
MRO inventory are the items that keep your business functioning, such as spare parts, equipment, and tools, etc.
Using these inventory types, you can group your items together and then begin improving the layout and placement of your stock and factory floor.
You might be wondering how does reorganizing your factory fit in with talking about inventory rule.
So, you’ve investigated which items provide the most value and which type of inventory they belong to.
By focusing on your routing manufacturing, you can further classify your items by different categories and keep them stored where it’s most convenient.
Doing this will be crucial in helping you implement the 80/20 inventory rule.
For example, let’s imagine you manufacture t-shirts, you’ll want to organize your items by three tiers:
Tier 1 – Group items by if they’re made for men or women;
Tier 2 – Break down those two groups by sizes; and
Tier 3 – Classify these items by SKU’s.
By grouping items together like this, and using SKU’s, will help you and your colleagues easily find items in storage.
This brings us to the next step, actually implementing the 80/20 rule and organizing your storeroom and shop floor to get the most out of your business.
How to Categorize Your Inventory?
There are several ways you can categorize and organize your inventory, and the most common way of implementing the 80/20 inventory rule is by using the ABC method to help you determine the most optimal way of storing your items.
ABC inventory is heavily inspired by the Pareto principle, but instead of looking at everything so clear cut, ABC inventory takes your items and divides them into three categories:
A Items – 15% of your produces that account for 70% of sales;
B Items – 20% of your products that account for 20% of sales; and
C Items – 65% of your products that account for 10% of sales.
The idea is to have ‘A’ items fully stocked and in easy to reach places, be that raw material that should be as close as possible to the shop floor, finished goods in storage at the front of your inventory, or items front and center for customers to easily see in your store.
‘C’ items you can consider as support, these items should be handled the opposite way to your ‘A’ items.
By using the classifications above and organizing your stock with ABC inventory, you’ll be well on your way to implementing the ABC inventory rule within your business.
But, the big enchilada, why is it so important to have inventory rules in-place, and not just guesstimate your way to success?
Why it’s Important to Follow the 80/20 Inventory Rules?
It’s important to adopt inventory rules such as the 80/20 one because it’s a quick and easy way to implement lean manufacturing into your business.
But more specifically, adopting the 80/20 rule across your business allows you to refocus your efforts and capital on the inventory items and processes which provide your business with the most value.
To simplify the importance, the whole idea of adopting 80/20 is to only expend energy on the 20% of your business that brings you results and to trim the fat of your:
Manufacturing processes; and
Any other area of your business that can be optimized.
Advantages of Using the 80/20 Rule
The biggest benefit of following this inventory rule is that it can give you a quick insight into any low hanging fruits and fix any bottlenecks in your business.
Ultimately, it’s an easy guide to follow that can help you focus your resources on the areas of your business that brings you the most rewards.
Disadvantages of Using the 80/20 Rule
As mentioned already, the 80/20 inventory rule is not a law, so it’s not an accurate way of measuring your productivity in any way.
This is mostly because the split might not truly be 80/20, it could be 70/30 or 55/45.
The idea is to use the 80/20 inventory rule as a framework for assuming that a small percentage of your business brings most of the results.
For a clearer picture of how your products are selling or how efficient your production lines are, you’re going to need to implement a Smart Manufacturing Software that can capture this data for you.
Follow Inventory Rules with Katana Smart Manufacturing Software
Katana is an all-in-one cloud-based tool, meaning it’s accessible anywhere with an internet connection, for manufacturers looking to stabilize and scale their business, by giving them the power to improve:
Shopfloor management; and
Procurement, sales, and manufacturing order management.
Katana comes equipped with a ton of features that are specialized in helping you gather as much information as possible about your inventory, so you can implement the 80/20 inventory rule, and increase your efficiency even further.
Katana automatically tracks your COGS based on the average cost of related products sold. These costs are calculated by the items selling price, the material costs, and the cost of manufacturing.
Katana also breaks down your total sales revenue, taxes, and profit, so you can check the financial status of your on-hand inventory, or search through historical data to see how prices have fluctuated.
Set Reorder Points
Never be caught off guard again with low or no inventory when a customer places an order.
Reorder points allow you to configure your Smart Manufacturing Software to highlight items when inventory reaches a below-ideal-level of stock, so you can immediately order more materials or manufacture more goods, safe with the knowledge you still have safety stock available as you replenish your wares.
Katana offers manufacturers customizable packages, so they can pay for exactly what they need.
For example, with the Katana’s Advanced plan, you can get access to full end-to-end traceability of items, and a separate app for colleagues on the shop floor, who can report on their own progress and track the actual consumption of items from on the line.
All the tools manufacturers need to track and grow their business.