The Role of Pareto's Law in Inventory Control Techniques

Whether or not you're familiar with the economic principle known as Pareto's law, you may have observed its effects. Pareto's law holds that in a given system, a relative handful of "causes" will produce the majority of "effects." For example, you may find that 20 percent of your customers are responsible for 80 percent of your sales, or that 30 percent of the product lines you sell result in 70 percent of your returns. Pareto's law has applications throughout business, including inventory control, where it forms the basis for a technique called ABC analysis.

The law is named for Vilfredo Pareto, an Italian economist who studied land ownership in Italian in the early 20th century and found that roughly 20 percent of the population held title to about 80 percent of the land. Legend has it that he further developed the theory upon observing that 20 percent of the pea pods in his garden produced 80 percent of the peas. For this reason, Pareto's law is often referred to as the "80/20" rule. There's nothing "magic" about the 80 percent figure, though. Many business systems do in fact show an 80/20 relationship; others don't. But the overall point still stands: A relative handful of things will generate the bulk of the results.

Businesses that maintain an inventory of goods to sell to customers commonly observe a Pareto distribution in the value of that inventory. For example, a company might determine that 20 percent of the products in its inventory account for 80 percent of the total value of inventory. Managing inventory is time-consuming and expensive. By understanding that a few items represent the vast majority of inventory value, a company can get the most bang for its buck by focusing its inventory control efforts on those particular items.

The inventory control technique known as ABC analysis builds on Pareto's law. In ABC analysis, a company reviews its inventory and sorts all items into three categories, called "A" items, "B" items and "C" items. The typical breakdown might look like this: "A" inventory: 20 percent of products, 80 percent of value. "B" inventory: 30 percent of products, 15 percent of value. "C" incentory: 50 percent of products, 5 percent of value. Again, a particular company's numbers may be different, but managers should be able to discern a similar kind of pattern.

Once a company has conducted its ABC analysis, it can devise an inventory-control strategy that focuses effort where it will have the greatest effect. Items in "A" inventory are tightly controlled, meaning the company keeps close tabs on how much it has in stock; pays close attention to current demand and forecasts for future demand; and carefully plans its ordering so that it neither runs out nor winds up with too much excess inventory that can become obsolete. Items in "B" inventory are also watched closely, but the company reviews its ordering strategy less often. Since items in "C" inventory are the least expensive, the company can order them in bulk and exercise minimal controls; all that really matters is that the company doesn't run out.