The ABC Philosophy

In the above example it is easy to see where time is best spent, but in the hustle and bustle of day-to-day business we often lose sight of the priorities. The wise old adage - “Take care of the pennies and the pounds will take care of themselves” - could not be more wrong, so forget it.

Mathematicians have come up with a myriad of complicated algorithms to determine the optimum order quantities and order points for items in various circumstances. This is fine, as it enables computers to efficiently calculate recommended stockholding parameters for the majority of low value (C class) items, rather than spending unproductive time trying to control these items manually. It is the few high value (A class) and critical items which should take up most of the inventory controller’s time to ensure money is not wasted by having excessive stocks of high value items, or by stopping production due to a stock-out of a critical item.

The same philosophy applies to contract administration, legislation and tax systems.

All contracts, including the social contract governments have with the people, should always be as simple as possible, and only as complicated as necessary. Only the few high value and complex agreements (A class contracts) warrant complicated legal documentation.

And yet we still see voluminous and complex terms and conditions in fine print on the backs of the most basic order documents. People tend to make things complicated to justify their existence and protect their own job, or worse, to camouflage deceit or intended corruption. Some of the standard contract clauses I saw when I first studied contract law were obviously written by lawyers wanting to guarantee they would be required to interpret them in any dispute. That was many years ago, in the days before we started demanding simple-English contracts.

We have come a long way since then, or have we?

A look at a typical insurance policy document, or the risk management clauses in a set of standard terms and conditions, or one of the many new pieces of simplified tax legislation is enough to boggle the mind. It is no wonder the insurance industry has found itself in crisis, and unless some real simplification occurs in these areas, many other industries will also be in crisis.

We have covered ourselves with so much legal jargon and red tape that fewer and fewer people are prepared to take a risk. Not a good climate for investment. The majority of transactions we encounter day-to-day are low value (C class) and low risk, so simply maintaining a competitive marketplace should be sufficient to keep the parties honest, without the need for overly complicated contracts.

One would expect that our advance toward globalisation would improve competition by opening up markets to more traders. However, the reality can be quite different. To compete on the world stage, companies must grow in size and sophistication. We are seeing more mergers and takeovers. Ultimately, we could end up with monopolies on a global scale.

On a worldwide playing field, global corporations can afford to carry losses over a prolonged period in localised areas to eliminate local competition. Their losses are offset by the huge profits they make in areas of the world where they have achieved market domination. At this point, “Big” definitely ceases to be beautiful. It becomes a big step back toward the feudal system.

If we are to truly advance as a society, and fully develop the potential long-term benefits of globalisation, we must get the basics right.

Keep it simple, never forget your ABC’s, and always strive to maintain the balance between Supply & Demand by fostering competition wherever possible.

Graham Duncan

The ABC PHILOSOPHY is an established principle, which holds that ten percent (10%) of all items or transactions account for seventy percent (70%) of the total value of those items or transactions, and vice versa. It is a statistical fact that applies to any activity, over a reasonable population sample.

Long seen as the basis for good inventory control, the ABC PHILOSOPHY, also known as the 80-20 Rule, or Pareto Principle, can be used to great advantage in all financial activities by concentrating on the areas of highest expenditure and greatest potential savings.

To allow Supply staff the time to concentrate their efforts on the big dollar (A class) transactions, the 70% of small (C class) transactions, which tend to take up most time, need to be managed efficiently. Instead of getting three quotes for every item as it comes up for order, repetitive purchases should be catalogued and grouped in commodity and supplier or manufacturer categories. Any reasonable computerised supply system can capture the historical usage and item costs on an annual basis, and provide reports which can identify the A, B and C class items.

Groups of C class items should then be put out to tender, and contracts awarded on the basis of the best value for the group (NOT item by item). These items can then be ordered automatically as required from the contracted supplier without taking up any more of the purchasing or contract officer’s valuable time.

Experience has proven that the tender process produces significant price reductions for such commodity contracts, although who cares if you pay a little more for some C class items, because the time saved by this approach is considerable, and is time that can be spent negotiating really big savings on the A class items.

Consider this example:

Total annual expenditure for all purchases is $10 million. Therefore, annual expenditure on C class items is $1 million and annual expenditure on A class items is $7 million. All C class items are contracted and the overall saving on those items is 10% or $100,000. However, in the extra time you now have, you also negotiate an overall saving on the few A class items of 10%. This adds $700,000 to your reported annual savings and you really do deserve that big pay rise.