Has the Pareto Principle finally reached its expiration date after 110 years? Why the tail wagging the dog heralds the end of the 80-20 rule in procurement.
This article was first published on EBN Online.
When Vilfredo Pareto observed in 1906 that 80 per cent of the land in Italy was owned by 20 per cent of the population, little did he know that this 80-20 rule (or Pareto Principle) would be enthusiastically embraced by the procurement profession and still be applicable 110 years later.
The term was popularised in the 1940s by the engineer Joseph M. Juran, who famously wrote of “the vital few and the trivial many”.
In procurement terms, the Pareto Principle means that 20 per cent of the average organisation’s suppliers account for 80 per cent of spend, and vice-versa. I’m a big fan of explaining procurement concepts with relatable imagery, so let’s picture your supplier base as something that we’re all familiar with – a dog.
The Tail Will Soon Be Wagging The Dog
Picture a Labrador. Or an Alsatian, or a Sheep Dog if you prefer – whatever takes your fancy. The head of the dog could be said to represent your top 1 per cent strategic suppliers. This is where you commit most of your time and energy.
Your procurement systems are optimised to work with the head of the dog. You make a significant effort to communicate face-to-face, and you spend a large amount of time worrying about what’s going on inside that head.
Let’s move down the neck to the dog’s body. Think of this as the next 19 per cent of your strategic suppliers. While the body isn’t nearly so important as the head, you recognise that this group accounts for the majority of your spend and deserves almost as much attention. As such, you dedicate time and resources to ensuring the body is in optimal health, and these “vital few” are being properly looked after.
Finally, the tail. Depending on the amount of suppliers you have, this could be a short stubby tail, or an extremely long one that tapers to a tip. Into this tail you’ve crammed 80 per cent of your suppliers – Juran’s “trivial many” who represent only 20 per cent of your spend.
You’re so busy looking after the dog’s body (and especially its head), that you’ve adopted a set-and-forget approach to the spend tail. You automate what you can, and call upon the smallest suppliers only when you need them.
And that’s a mistake, because in terms of innovation potential and risk profiles, the tail will soon be wagging the dog.
Procurement Systems Optimised For Large Suppliers
And yet most of our systems, or proprietary networks, only give us visibility of a few hundred thousand. We need to develop open networks to give unhindered access to all these suppliers who could potentially be the source of game-changing innovation.
The problem is that our processes and systems are set up to work with the big players at the expense of SMEs. “We can’t have our bureaucracy, our complexity, our layers of organisation impact suppliers’ businesses,” says Perez. “The cost of business goes up”.
Yet, that’s classic procurement, and it takes a culture shift to change the way we do business and encourage a truly open network. Think about the hurdles your organisation is putting in place for SMEs; whether they’re prohibitive insurance requirements, or crippling contractual terms that could bankrupt a small player.
Are they really necessary? Are you closing the door on opportunity because you see yourself as too big to play in the small supplier space?
Building Culture Of Agility And Innovation
Have you ever requested a last-minute change from a large supplier and watched in frustration as the creaky wheels slowly begin to turn? By the time the suppliers’ emails have bounced around to tick all the bureaucratic boxes, a smaller supplier may have found and implemented a solution.
What you want is agility. And small suppliers will expect you to be agile in return.
In her workshop on innovation in procurement, former Deutsche Telekom CPO, Eva Wimmers, stressed the need for nimbleness when working with SMEs. She discovered that the existing processes at her organisation were skewed towards the largest suppliers.
Processes were changed to encourage innovation through diversifying the supply base to include more SMEs and start-ups, cutting new contracts down to a maximum of five pages, and holding supplier meetings exclusively around innovation.
Eva also implemented what she called “dialogue-rich procurement”. This encouraged her team to greatly increase their communication with both internal stakeholders and with suppliers. Her team discovered that SMEs, in particular, were very eager to share their ideas when they found that procurement was willing to listen and learn.
In Eva’s words, “We do not care how big an organisation is, as long as both the solution and the organisation are scalable and financially solid.”
She used Dropbox.com as an example of a small organisation with fewer than 50 staff that wouldn’t even have shown up on many organisations’ radar. And yet now it has world-wide take-up.
Compression Of The Supply Chain
Robotics, 3D printing and computer-aided design are demolishing the old economies of scale, and separating a big supplier from an SME. This is ushering in no less than a “Fourth Industrial Revolution”. What this means for procurement is that third or fourth-tier suppliers can find themselves rapidly rising to first-tier producers of end-products.
“There will be huge opportunities for companies further down the supply chain to innovate,” Markillie said. “Second-generation robots are more affordable for medium and small companies; 3D printing processes are less wasteful of raw materials and allow greater production flexibility at lower volumes.
“I think we will see some companies grasp these opportunities, which could re-order supply chains, and lead to some companies that were previously suppliers of components making the leap to become producers of final products.”
Lots Of Risk In That Spend Tail
The dilemma many procurement professionals face is that although you can’t afford to spend much time with suppliers beyond your top 20 per cent, every single vendor in your supply chain presents a significant risk to your brand, reputation and bottom line.
Think about a small supplier that you only use sporadically. Have you investigated their suppliers to ensure compliance to standards? What are their second-tier suppliers up to? What about the third, fourth and fifth tier?
Even though your spend with this supplier may be minimal, it can cause just as much damage to your organisation as the top 20 per cent. Child labor, slavery, cyber security, unsafe practices – the list is endless, and frightening.
My point – apart from trying to scare you – is that your risk mitigation and audit processes that are in place for the top 20 per cent, should be extended to the remaining 80 per cent.
End Of The Pareto Principle?
So, does this mean that the Pareto Principle has finally reached its expiration date after 110 years? In my opinion, yes it does.
If you measure the importance of suppliers purely by spend (and that’s very old-fashioned thinking), then you should indeed spend the majority of your time with the 20 per cent.
But modern CPOs know how badly a bottom line can be hurt by a risk event, and the huge potential of disruptive innovation to grow a business. And both of these factors reside in suppliers of every size, including those in the tip of the tail.