Pareto Principle

The Pareto Principle derives its name from a respected economist Vilfredo Pareto. This principle states that 80% of the consequences are a result of 20% of the causes. Hence, this principle signifies that the relationship between inputs and outputs is not equal. More generally, this principle is an observation that most things in life are not in balance. The Pareto Principle is also popular among academicians as the Pareto Rule or the 80/20 rule.

Emergence of the Pareto Principle

Vilfredo Federico Damaso Pareto gave the world the concept of this principle. He was an Italian by nationality and was born in 1848. It is said that one day he observed what is today known as the Pareto Principle in his garden. So, one day he observed that 20% of the pea plants in his garden generate 80% of the healthy pea pods.

This observation in the garden made him think about uneven distribution in many other things. He now thought about the distribution of wealth in Italy. Interestingly, he discovers that 20% of Italy’s population holds 80% of the land in Italy. After surveying a number of countries, he found that the observation holds true even abroad. He then did some investigation on different industries to find out the ratio of different companies to the total production. Again, he found that 80% of the production in any industry came from the top 20% of the companies.

The generalization of these observations came as follows:

80% of the results will come from just 20% of the actions.

80/20 Rule in the Pareto Principle

The “universal truth” about the imbalance of inputs and outputs finds its applicability in a wide range of areas such as manufacturing and management, etc. While it does not need to be an exact 80/20 ratio, it is generally seen that:

  • For employers, 20% of salesmen generate 80% of the total sales.
  • In the case of a factory, 20% of workers produce 80% of the total product.
  • For any business, 80% of the total profits come from just 20% of the customers.

Time management is also a very common field where the Pareto Principle finds its application. Most people tend to thinly spread their time over a number of tasks instead of focusing on the most important ones. Hence, the Pareto Principle suggests that one should spend 80% of one’s time on 20% of the most important tasks and will 80% of the result.

Example of the Pareto Principle

So, how can we apply the Pareto principle in our professional life or in businesses? Consider this example. Suppose you are a manager at an IT firm having so many clients. The principle suggests that 20% of your clients will account for 80% of your business. So, this 20 % of clients deserve 80% of the customer service, correct? As human nature suggests, however, this is quite not possible. Most managers try to spread their time evenly across all the clients. Although it is not quite possible to divide your time in the 80/20 ratio with the clients, the principle suggests that the manager should try to spend most of his time (ideally 80%) in building a relationship with the top 20% of his clients.

Pareto Chart

Sometimes, it becomes challenging for the managers to understand what the causes behind the problems in their companies are. Instead of dealing with the root cause of the problems, they spend their time-solving problems as they arise. These problems, however, never cease to end. These managers may find the Pareto Chart of some help to defeat this situation. It can help them to segregate the problems and their causes, finding out which cause is responsible for the greatest number of problems.

The Pareto chart is an extension of the Pareto Principle and is one of the basic tools of quality management. It is a simple bar graph with causes on the x-axis and the number of times that cause was the reason for a problem on the y-axis. To understand better, let’s take an example.

Pareto Principle

Preparing a Pareto Chart

Suppose a shoe manufacturing factory wants to know what is the root cause for the defects in the shoes manufactured in the factory. The managers at this company identify 4 categories of causes. The defect can be due to (a) poor fabric supplied by the suppliers, (b) workers did not stitch the shoe properly, (c) poor quality of stitching material used in the factory, or (d) the defect was a result of the machine malfunctioning. The factory will draw four bars against the four causes on the x-axis and the frequency of the causes on the y-axis.

So, after analyzing the bar graph, the factory may come to know that a majority of the defects (say, 80%) were a result of poor fabric supplied by the suppliers. Hence, this suggests that the factory needs to change its suppliers- a root cause. Or, the graph may suggest that 60% of the time, the defect was due to a machine malfunctioning, suggesting a replacement of the machinery.

Advantages of the Pareto Principle

Using the Pareto Principle, a business can reap certain benefits, which are discussed in this section.

Increased Productivity

The Pareto principle is very helpful for managers to identify which are the areas where they should focus their efforts and resources to get maximum results. By using the 80/20 rule of the Pareto principle, managers and employees can design their schedules to focus on the crucial 20% of the tasks. This principle helps managers and employees to avoid wasting time on many trivial matters which will not contribute significantly to the results. Hence, this principle enhances productivity.

Increased Profitability

Using the Pareto Principle, a firm can definitely improve its profitability. In our previous example, we established that 20% of the clients for that IT firm would provide 80% of the business or profitability. If the firm starts focusing more on this 20 % of clients, it can significantly increase its profitability as the top 20% of clients represent most of the firm’s business.

Website Optimization

Pareto Principle can also help you with website optimization. The 80/20 rule suggests that an overview of your business’s website analytics will show that 80% of the traffic on your website goes to 20% of the website’s pages. So, 20% of the pages become critical for the success of my website. Hence, you will ensure that 20 % of the pages are appropriately designed and are easily accessible to anyone.

Improve Customer Satisfaction

Customer satisfaction is important for any business, and the Pareto principle can help you to improve it. As per the Pareto Principle, 80% of the customer complaints will relate to 20% of the causes. So, if you focus on those top 20% causes, you can eliminate 80% of the problems out of the system. Hence, lesser problems and better customer satisfaction.

Disadvantages of the Pareto Principle

Focus on the Past

The Pareto Principle provides useful data on how some factors are the cause of past problems. But the same factors may not be responsible for future problems. This is because the past situations for a business may change now, and so the earlier causes may not be the reason now.

Inaccurate Decisions

The Pareto Principle may result in making inaccurate decisions because of a narrow view. E.g., the Pareto principle will suggest that 20% of the clients account for 80% of the profits. So, as per the principle, a business should focus most on this 20 % of clients. However, the remaining 20% of the clients may be thinking about bringing more business in the future. If a manager ignores this 20 % of clients, he may harm the future profitability of the business.

Quantitative and not Qualitative

The Pareto Principle deals with only quantitative aspects and not qualitative aspects. This may result in inaccurate problem-solving. E.g., suppose a business wants to cut costs and identifies 20% of the top cost centers which are responsible for 80% of the costs. But these top 20% of cost centers may be critical for the success of the business. A cost-cutting in such centers may do the business more harm than good.

Improper Splitting

The spilt of 80/20 by the Pareto Principle may not always hold true. For instance, 35% of the workers may produce only 65% of the output. In such cases, the Pareto Principle will fail to be of any use. This repeats the fact that the Pareto Principle is only an observation and not a law.

Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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