Platt Perspective on Business and Technology

Inventory management and a possible misuse of the Pareto Principle

Posted in strategy and planning by Timothy Platt on March 31, 2014

I have written about the Pareto Principle and its applications a number of times in this blog and note here that I will be discussing its use again here. And in that context, I also note its other commonly used name: the 80-20 rule. And I have written about retail businesses a number of times too and about issues related to their inventory management, and particularly where they have limited space for holding stock that they cannot put directly on the shelves for immediate sale, limited liquidity that they can tie up in unsold inventory, or both. And I write this posting with these businesses and these contexts for them in mind too.

If you look at the inventory turnover rate – the speed at which inventory brought in is sold and leaves the business through sales transactions, it is common to find that some 80% of all sales transactions and some 80% of all revenue and profits generated from them come from sale of some 10% of the stock keeping units (SKU) held in inventory. These short-tail product offerings drive the business. And the remaining 90% of item types stocked and offered for sale includes long-tail inventory offerings that might remain on the shelf for extended periods, both tying up the cash that is needed to bring them into the store and taking up shelf space that could otherwise be used for displaying other types of goods.

A simple and obvious resolution to this, or at least a simple and obvious ongoing process for addressing it is to continually cull out slow sellers, moving stock that is not going out the front door as regular sales fast enough, to discount and sales item tables and not bringing in new stock to replace them. Or this excess and unfocused stock can be remaindered over to a discount business that specializes in acquiring slow moving inventory from more mainstream businesses at discount prices, and selling them to a consumer base specifically looking for discount savings. And of course this is all done in the context of seasonal sales items and with overstock on SKU’s that did not sell at usual peak sales times being discount offered in-store or shipped out to those discount-oriented businesses for them to sell to end-users. Christmas cards come immediately to mind as a working example here. Before December 25, sales might be good for them. After December 25, the only people who are going to buy boxes of these cards are the ones who are looking for steep sales discounts, intending to buy now for the next year’s holiday seasons – even if they do sell brusquely at that store leading up to Christmas.

So I begin this with a simple, baseline business model approach:

• As a basic, default approach to inventory selection, identify the 10% of item types that sell at that 80% of business level and stock the shelves heavily with them.
• Identify the slow sellers and particularly the slowest sellers and cull them out very actively, and even as a matter of culling out of inventory some set percentage of lowest sellers every single month as a basic set practice.
• And bring in seasonal sellers very selectively on the basis of your own business’ historical seasonal sales history and carefully selected third party market intelligence.

This default approach does work, but my goal here is to add a very specific inventory selection consideration to that business model’s approach.

• Many and in fact most people who walk into a supermarket want to be able to buy everything on their shopping list in that same one place and at the same time. This includes the top 10% items on their list that can be expected to account for that 80% of this store’s overall business but it also includes those long tail items that this customer wants, and wants now too.
• Chances are that every supermarket, every bodega and smaller food store – every competitor in the area is going to carry every one of those top selling 10% items because every one of them will find essentially the exact same list of inventory items flying off of their shelves at that faster rate too. They will for the most part have the same inventory items in all of their top 10% lists with differences primarily found in competitors who specialize in serving particular ethnic communities. Even there, many of their top 10% items will be the same as would be found in the local supermarkets too.
• So what makes a customer select one supermarket over another might very well hinge on how easily and reliably they can fill out the rest of their shopping cart with the other items they have on their list that might in and of themselves sell at a slower rate – but that because of the average shopper’s behavior and preferences can drive that store getting to make any sales to them at all – at least that day and time.

This is all about what types of sales correlate with what other sales. Birthday candles might sell at a slow rate but people who go into a supermarket to buy them are likely to also buy other things needed for a party too. Note that this might mean a slower selling item correlating for sales likelihood with specific other items (e.g. buying a box of birthday candles or fancier number candles, and also buying a cake from the store’s bakery department.) But this can also mean some individually slower moving items correlating for their sales with making significant amounts of other purchases in general.

What this means is that:

• Simply looking at the rate of sale of one particular SKU item can offer insight, but if this is all you do you can lose out on seeing and benefiting from larger recurring patterns too.

This does not mean never culling out slow selling items from your ongoing inventory. It is about knowing your customers and your market demographics, and the types of things that customers are likely to buy together. And when you know that, you can think and plan more effectively in terms of marketing combinations of items that you might not initially see as connected but that experience would show your customers do. But capturing the marketing and sales synergies that this can make possible is the topic of another posting.

Meanwhile, you can find this and related postings at Business Strategy and Operations – 3 and also at Page 1 and Page 2 of that directory.

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