PARETO ANALYSIS AND SUPPLY CHAIN MANAGEMENTPareto Analysis

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Knowledge Bite

Pareto Analysis and SupplyChain Management

This knowledge bite aims to give an

insight into the concept of Pareto

Analysis.

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PARETO ANALYSIS AND SUPPLY CHAIN MANAGEMENT

1. Introduction

The Pareto principle serves as the basis for ABC analysis (also known as the 80/20 or 90/10

rule) with which it is often, though not entirely accurately, regarded as synonymous. ABC

analysis may be defined as:

“The application of Pareto's principle to the analysis of supply data. If items in a store are

arranged in descending order of usage-value and the cumulative number of items are plotted

against the cumulative usage-value the result would be (expected to) show a curve of the

general form associated

with Pareto's Principle.”

In a store, stock may be categorised in broad accordance with the Pareto principle as follows: • Group A: Items that account for 10% of total volume, but account for 60% of total stock value.

• Group B: Items that account for 30% of stock volume, and account for 30% of stock value.

•

Group C: Items that account for 60% of total stock volume, but only account for 10% of total stock

value.

• This segregation of stock into volume value groups enables the stores manager to allocate resources

to maximum effect.

2. Origins of the concept

Vilfredo Pareto (1848 - 1923), economist and sociologist, and widely held to be the founder of

modern welfare economics, made the observation that a large proportion of national wealth

tended to be under the control of a relatively small number of individuals. This enabled him to

formulate the following rule:

“In any series of elements to be controlled, a selected small factor in terms of the number of

elements almost always accounts for a large factor in terms of effort.”

Although this topic file focuses on the application of the Pareto principle to the supply chain,

the theory is equally applicable to a wide range of situations. To take an everyday example - it

is a matter of simple observation that the majority (say 90%) of traffic in the UK is carried on a

relatively small proportion (say 10% in terms of mileage) of the total road network.

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There is a considerable volume of literature relating to category C - items which are of low

value but which due to their number represent a considerable expenditure in terms of stock

control, order and procedures. The concept of EOQ (Economic Order Quantity) represents at

least a partial solution to the problem.

The principle of ABC analysis may be illustrated by reference to the following everydaydomestic example, taken from CK Lyson’s book Purchasing and Supply Chain Management

(Prentice Hall, 2000):

“A household will buy many different items in the course of a year. The weekly shopping will

include a number of basic food items such as bread, milk, vegetables, etc.’

These basic items are so important in the household budget it is worthwhile taking care to

choose a shop that gives good value. Information about the prices charged elsewhere can be

obtained from advertisements and visits to other supermarkets. In ABC analysis these items

are known as Class A items. These items merit close day to day control because of their

budgetary importance.

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Other items such as replacement rubber washers for water taps may be needed occasionally. A

packet of washers costs between thirty and fifty pence. Spending hours comparing the price

from different suppliers does not make economic sense. The possible saving is at most twenty

pence and a year or more may elapse before another packet is needed. Items like this thataccount for only a small proportion of spending are known as Class C items.

Experience and common sense shows that it is not cost-effective to set up elaborate and costly

controls for small-value items. Common sense also suggests that, at the ordering stage of the

procurement process, the time spent on processing low-value orders represents an inefficient

use of resources. In fact the problem of low-value orders is widely recognised as a topic in its

own right in the literature.

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PARETO ANALYSIS AND SUPPLY CHAIN MANAGEMENTPareto Analysis