Pareto Principle – Meaning, History, 80/20 Rule and Example

What is 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.

History 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 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

  1. Poor fabric supplied by the suppliers.
  2. Workers did not stitch the shoe properly.
  3. Poor quality of stitching material used in the factory,
  4. Or 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.

  • It improves efficiency by focusing on result-oriented areas.
  • Helps in improving profitability.
  • Helps in improving customer satisfaction.

For more detail, refer to the Advantages of the Pareto Principle.

Disadvantages of the Pareto Principle

  • It is based on past data.
  • False decision due to improper splitting.
  • Based on the quantitative and not qualitative aspect.

For more detail, refer to the Disadvantages of the Pareto Principle.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

1 thought on “Pareto Principle – Meaning, History, 80/20 Rule and Example”

Leave a Comment