The Pareto Principle, also known as the 80/20 Rule, refers to a statistical regularity observed in a number of areas. According to this rule, 80% of overall value comes from 20% of the most important items. Procurement has embraced this principle to prioritise its purchases using three categories: A, B and C also named Tail spend. However, appearances can be deceptive.
What is the Pareto Principle?
In the 19th century, Italian sociologist and economist Vilfredo Pareto conducted a statistical study on income inequality in Italy. The study found that, on average, 80% of the country's wealth was held by 20% of its population. Intrigued by this observation, he then converted this income-distribution law into a mathematical formula.
A few decades later, Joseph Moses Juran coined the term "Pareto Principle" to mean that about 80% of overall value is produced by 20% of the most important items. This statistical regularity, also known as the 80/20 Rule, has since been observed in many areas.
For example, it is said that:
- 80% of a company's turnover is generated by 20% of its customers
- 80% of income tax comes from 20% of earners
- 80% of storage space is occupied by 20% of products
- 80% of complaints are made by 20% of customers
This rule highlights the importance of optimising resources to achieve the best return. In other words, we need to focus on the 20% to produce 80% of the results. In the world of procurement, this raises the issue of cost optimisation.
Class A, B and Cpurchases,also named Tail spend
Procurement uses a Pareto-inspired classification system known as the "ABC Method" to prioritise its purchases.
There are three distinct categories:
- Class A purchases account for 80% of the total cost of purchases for 20% of suppliers
- Class B purchases account for 15% of the total cost of purchases for 30% of suppliers
- Class C purchases,also named Tail spend account for 5% of the total cost of purchases for 50% of suppliers
In line with the Pareto Principle, procurement departments have focused on controlling purchases with a significant impact on overall value, i.e. Class A or maybe Class B.
The third category, which on the face of it is not as important, has long been neglected by buyers. However, the reality is quite different. Although they represent just 5% of total purchase costs, Tail spendaccount for the majority of indirect costs (managing suppliers, placing orders, costs of poor quality, unscheduled purchasesetc.). Therefore, when viewed through the lens of TCO (Total Cost of Ownership), Tail spend clearly deserve procurement departments' attention.
Optimising Tail spendis now a means of giving a company a competitive advantage, or can even demonstrate a certain level of maturity within their procurement departments.
I am an expert well-versed in the concepts surrounding the Pareto Principle, often known as the 80/20 Rule. This principle, originating from Vilfredo Pareto's observations on income inequality in 19th-century Italy, has extended its influence across various disciplines due to its statistical regularity. Joseph Moses Juran later coined the term "Pareto Principle," emphasizing that roughly 80% of value derives from 20% of the most significant items.
The Pareto Principle has been notably observed in multiple domains:
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Wealth Distribution: Pareto's initial observation noted that approximately 80% of a country's wealth was owned by 20% of its population.
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Business and Economics: It's often cited that around 80% of a company's revenue comes from 20% of its customers. Similarly, 80% of complaints may stem from just 20% of customers.
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Resource Allocation: This principle extends to resource utilization, where roughly 80% of storage space is taken up by 20% of products, illustrating an uneven distribution.
In procurement, the Pareto Principle manifests in the classification system known as the ABC Method, categorizing purchases into three groups:
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Class A Purchases: These constitute 80% of the total procurement costs but involve only 20% of the suppliers.
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Class B Purchases: Accounting for 15% of the total cost, these engage 30% of the suppliers.
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Class C Purchases (Tail Spend): Despite making up only 5% of the total cost, they involve 50% of the suppliers.
The misconception often arises concerning Tail spend, perceived as less significant due to its low cost percentage. However, these purchases, in reality, incur a substantial share of indirect costs, encompassing supplier management, order placements, costs associated with poor quality, and unscheduled purchases. When evaluated through the lens of Total Cost of Ownership (TCO), Tail spend demands the attention of procurement departments.
Optimizing Tail spend is increasingly regarded as a means to gain competitive advantages and signify a level of maturity within procurement departments. It highlights the importance of focusing on seemingly less critical elements to achieve a more comprehensive and effective resource utilization strategy, aligning with the overarching principles of the Pareto Principle.
