25 Mar 2020

The Pareto Principle (80/20 Rule): Why It’s So Important

You may well have heard of the Pareto principle. Another common name for it is the 80/20 principle, or rule.

It’s named after the Italian economist, Vilfredo Pareto.

If the name rings a bell, it’s most likely because you’ve heard somebody use the term “pareto distribution” or “a pareto analysis”.

Now you know where the term comes from!

The 80/20 rule was an observation made in the 19th century, when Pareto was looking into how land ownership was distributed in his native Italy.

He observed that 80% of the land was owned by 20% of the landowners.

He then went on to observe that 20% of the pea plants in his garden produced 80% of the total yield.

The Pareto principle itself isn’t hard to understand. It’s simple evolutionary “survival of the fittest” rationale that ultimately holds sway when there are no intervening forces to skew natural law and market forces.

 

How the 80/20 rule can help you focus on more effective tasks

But what about how it can be applied to common problems in the procurement space.

Let’s look, for example, at the Pareto principle to observe opportunities and patterns when it comes to managing our supply base, especially on separating core vendors from tail spend.

This is actually one of the most powerful laws which can be applied.

For me, the most interesting aspect is the insight and validation it gives you to stop spending too much of your time and resource on “busy work”, to the detriment of where your real value lies.

 

Let’s look at some examples

The following statements quickly give clarity around how to free up white space and to unlock value.

The resource and energy saved can give your organisation extra capacity to concentrate on what’s important, whilst eliminating or ignoring what’s not.

Because at the end of the day, administrative work and tactical day-to-day issue resolution is the task of admin assistants and junior staff, not highly paid senior managers.

20% of vendors are the key partners who account for 80% of your total spend. How much time are you spending developing and partnering with them? And now check how much time you spend dealing with day-to-day communication with the long tail of irrelevant suppliers.

Is this a productive use of your precious time?

80% of your invoice volume is represented by the long tail of vendors who make up the last 20% of your spend. That’s 80% of the issues being caused by non-core vendors.

What if you had fewer vendors, or someone else who manages all of the noise while you get on with driving value to the business?

80% of the late deliveries or quality problems come from 20% of your vendors. 

If they’re key vendors, work with them. If they’re not, get rid of them.

20% of your stakeholders account for 80% of your time spent serving your internal business partners. Are they the ones who you need to be building alliances with, or just the ones who shout the loudest or who like working with you?

Who should you really be in front of to drive the most value and achieve your objectives. Are you using your email inbox as your de-facto “to do” list? Or are you consciously seeking out whom you should be building strategic alliances with?

And so on. You get the picture.

80/20 Squared

The other twist on this is when you start to apply the power law and perform 80/20 squared.

Take the 20% and then apply the 80/20 rule to this also.

You come out with 64%/4%.

If we’re talking about tail spend management, for example, then what this means in practical terms is if you’re applying the Pareto principle squared to strategically manage JUST the top 4% of your vendors, that will help you drive 64% of your results.

(Let’s assume for argument’s sake that we’re looking at vendors by spend, but it doesn’t necessarily have to be.)

Whether that focus is on traditional expense reduction targets, DPO improvements, on-time deliveries, supplier relationship management (SRM) and so on.

In short, 80/20, or even 64/4, is the ace card I always play when trying to convince sceptical stakeholders of the benefits of vendor consolidation.

That’s my speciality – and it fits perfectly with the Pareto principle and taking it to the next level to form a power rule.

So, surely it makes an economic, business case to:

  • Cut out the noise;
  • Free up the resources;
  • And drive results from the vendors who REALLY matter

Don’t get bogged down with operational issues being caused by a long tail of insignificant suppliers.

That’s where I can help you…

It’s not your core business, but it’s my area of expertise.

I can manage this spend for you, deliver bottom line savings that are several times my fees, and leave you to concentrate on driving value from your core vendors.

You can’t actively manage all of your suppliers, so cut the tail

Let’s take an average production site that has 250 vendors.

Your buyers are not actively managing all of them (unless you have a very big purchasing team!).

By actively managing them, I don’t mean communicating with them on a transactional level. That’s not really supplier management.

I mean understanding whether they’re a critical vendor to you, or whether they’re just more busy work that could be consolidated into a more strategic supplier, or purchased through a catalogue.

This is especially important if you don’t have a well-resourced buying team.

If we take the 80/20 rule squared and say that by managing just 4% of the vendors properly, they can deliver 64% of annual cost reduction target (or any metric for that example – we could just as easily be talking about improvements in on-time delivery), this is dynamite.

4% of 250 vendors is just 10 companies whom you should focus on to be your strategic partners, and they could deliver 64% of the total value.

The problem is freeing up the time to do this.

You can’t strategically manage your top 10 vendors if your team are chasing around dealing with delivery issues, invoice problems and price increases from the long tail of insignificant suppliers.

The key is to rationalise these and reduce the number of POs, invoices and deliveries received. There are many ways to achieve this, and there’s no “one size fits all” solution.

If you’d like to discuss how I can help you cut your team’s “busy work” of dealing with the long tail of suppliers, let’s have a brief intro call so as I can learn more about your business and the specific issue you’re looking to fix.