How to use the Pareto law to optimise your procurement strategy?

February 1st, 2024
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Also known as the 80/20 rule, the Pareto law refers to an observed statistical pattern whereby 80% of the total value is produced by 20% of the most important units. The procurement function has made this principle its own to categorise procurement into three tiers (head spend, mid-tail spend and long tail spend, or A, B, C) and optimise the associated strategy. However, it’s important not to rely solely on appearances and to consider other parameters.

Origins and definition of the Pareto law

In the 19th century, Italian economist and sociologist Vilfredo Pareto conducted a statistical study analysing the distribution of wealth in Italy. He observed that on average, 80% of the country’s wealth was held by 20% of the population. Intrigued, he then translated this law of income distribution into a mathematical formulation.

A few decades later, Joseph M. Juran introduced the term "Pareto principle" to signify that approximately 80% of the total value is produced by 20% of the most important units. It turns out that this statistical regularity is observed across various domains, including business.

For example, it is considered that:

â— 80% of corporate turnover is generated by 20% of customers;

â— 80% of tax revenue comes from 20% of taxable citizens;

â— 80% of storage space is taken up by 20% of products;

â— 80% of complaints come from 20% of customers.

By definition, this tool highlights the importance of optimising resources to achieve the best performance. In other words, the focus should be on the 20% that produce 80% of the results. In the purchasing world, this opens up considerations around optimising procurement categories and associated costs.

Head spend, mid-tail spend and long tail spend

The procurement function uses a classification method, also called the ABC analysis, inspired by the Pareto law to classify its purchases.

Procurement is thus divided into three categories:

• Head spend (A class) represents 80% of a company’s total expenditure for 20% of the total number of procurement segments;
• Mid-tail spend (B class) accounts for 15% of corporate expenditure for 30% of procurement segments;
•  Long tail spend (C class) represents 5% of expenditure for 50% of procurement segments.

As the Pareto law dictates, the procurement function has focused on getting head spend (A class) and mid-tail spend (B class) under control as these have a major impact on overall value. Long tail spend (C class), seemingly less strategic, has thus been neglected by buyers for a long time. However, the reality is quite different: Although it only represents 5% of the total procurement amount, it concentrates most of the indirect costs (supplier management, order placement, non-quality, maverick spend, etc.). Procurement departments must therefore consider this category of procurement from a Total Cost of Ownership (TCO) perspective.

Optimising long tail spend (C class) has thus become a competitiveness lever for companies, and even a sign of maturity within their procurement departments.

How to apply the Pareto law in procurement?

Applying the Pareto law to a company’s procurement strategy materialises through a real project management approach, following several stages of reasoning.

Creating a database

Procurement decision-making necessarily involves conducting an accurate assessment of the procurement portfolio. This database must be configured precisely based on several elements.

In a table, the following data should be indicated over one year:

• Product reference;
•  Product category;
•  Sub-category;
•  Supplier;
•  Turnover (in decreasing order);
•  Volume;
•  Share of total turnover;
•  Cumulative percentage of turnover.

It is from such a diagnosis that this classification can then be identified. If the cumulative turnover is over 95%, it is long tail spend; if it is over 80%, it is mid-tail spend. Otherwise, it is head spend. To properly represent the overall situation, a graph commonly called a "Pareto diagram" can also be associated with it.

configuration quite simply, thus initiating the digital transformation of procurement departments.

Considering all parameters

It is advisable to take a closer look at this mapping to prioritise tasks. Data analysis must take into account the company’s challenges as well as market constraints to build the procurement strategy.

Depending on the nature of its business, the procurement department must integrate additional parameters (price, delivery times, etc.) that will determine the level of attention to be paid to some suppliers over others. The identification of “vital” or “critical” elements for the production process must, of course, be placed at the very top of the priority scale, even if their volume remains marginal with regard to the order book.

It is also important to consider each supplier’s situation: Excessive geographical distance, geopolitical risks to supply that may arise, risks of cyberattacks on the supply chain, potential

monopoly situations or, conversely, fierce competition in the market, which will not have the same effects on production responsiveness. The above classification, either called ABC analysis or head, mid-tail and long tail spend analysis, should therefore not overshadow the importance of supply chain security, which remains fundamental.

Defining roles

To be fully efficient, the application of the Pareto law must be strictly supervised within the teams. The number of people with access to the database should therefore be limited to avoid any dispersion that would render its use ineffective.

In addition, each component of this database must be assigned to clearly defined roles between the procurement, finance or management control departments. Rules established from the outset will allow for better coordination between departments and avoid potential misunderstandings, detrimental in terms of costs, negotiating power or even delivery times.

Taking all these elements into account will promote this classification (head, mid-tail and long tail spend) and provide valuable decision-making support for the procurement department in optimising each of these segments.

Using the Pareto law thus enables procurement departments to optimise their resources and improve their overall efficiency. This classification makes it possible to adjust the strategy and optimisation levers according to each category. Lastly, the Kraljic matrix, another key procurement analysis and management tool, can be used in addition to this classification to refine the strategy, aiming for continuous improvement.

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