Pareto Analysis – Meaning, Application, Chart, Advantages and Disadvantages

Pareto analysis is a strategic option. Firms use Pareto analysis for decision-making. It is a logical approach to understanding the problem. It says that 80% of problems result from 20% of causes. In another format, we can also say 80% of success is due to 20% of the work done for the project.

The Italian Economist Vilfredo Pareto propounded this Pareto Principle in the year 1906. While researching the property holding pattern, he noticed that 80% of the property in Italy was owned by 20% of the population. Wealthy individuals constitute the 20% bracket of landowners. This helps us in understanding the concept of unequal distribution of wealth. In many developing countries, 80% of the income of a country is contributed by 20% of the population.

Later on, an American Engineer and management consultant, Joseph M. Juran, surveyed other countries and noticed a similar trend. To his surprise, this was a common observation in his findings. He went ahead and named it ‘Pareto’s principle of unequal distribution.’

In the modern world, Pareto analysis is also applicable in various types of business. It is a high-quality decision-making tool that scores the problems or parameters. The parameter with the highest score is of the highest value to the firm.

Pareto Principles Application

Various fields use Pareto analysis, be it any business. However, the most popular application is in quality control. For example, 80% of the delays are caused by 20% of the causes. 20% of the raw materials are responsible for 80% of the quality of the product. 80% of the product’s cost comes from 20% of the cost of raw materials. And the list goes on.

Steps of Pareto Analysis

There are five main steps for this analysis:

  1. The first step is to list down the problems affecting the business. A few common problems include customer complaints about product defects, delivery systems, etc.

2. The second step is to identify different causes that are the root cause of the problems identified.

3, The third step begins with scoring each problem according to its impact. The higher the score a problem carries, it will get, the higher its weight in the damage list.

4. The fourth step is to group similar types of problems. It is about segregating issues according to their nature or form. For example, customer complaints regarding delivery and product defects are two different groups of problems.

5. The fifth step is creating an action plan and devising a plan on how to solve such problems efficiently, smoothly, and quickly.

The Pareto analysis highlights issues that have a major impact on the business and are worth putting effort in. Minor issues can be managed for the time being, but identifying and solving the major issues is what creates huge value. And that be the focus and priority areas for the top management.

Pareto Charts

Pareto charts indicate the frequency of problems and the cumulative impact of the problems on the organization. To draw a Pareto chart, a mixed chart is used -A bar chart and a line graph.

The Y-axis of the Pareto Chart indicates the ‘frequency of the identified problems, and the X-axis represents the problems or issues. For example, Customer servicing is an issue, and the frequency of the occurrence of the problem is 25. The bars are in descending order; that is, the problem with the highest frequency is first, and so on.

The line graph on the charts shows the percentage of cumulative frequency of the issues. For example, if two issues together have a cumulative frequency of 68%, then these are the major defects affecting or spoiling the operations of an organization. Hence, working out a solution for these issues will help mitigate the issues to a large extent.

Pareto Chart

Advantages

Simple and Effective

Pareto analysis is simple, logical, and an effective tool in the decision-making process of the firm. Identifying major problems caused by 20% of the reason helps the organization to go to the root cause of the majority of the issues. Even if the rule might not always imply an 80:20 ratio, it can also be applicable for other problems. The ratio can vary slightly; however, the concept remains the same and have similar significance.

Understanding of Problem

Pareto charts are an effective tool for determining the major problems caused. It also helps us in understanding the overall impact on the organization. Removing the major block of the problem helps a firm achieve fast-paced growth and gain a competitive edge in the industry.

Decision Making Skill

Pareto analysis can help an organization identify problems and find alternate solutions quickly. The whole process sharpens the decision-making skills and creates a practice of dealing with problems as they come by.

Disadvantages

Use of Past Data

It is based on past data. Pareto analysis cannot predict uncertainty that will arise in the future. It helps in mitigating the issues faced in the past but does not predict concerns in the future.

Identification of Problem

It’s a problem and causes identifying the issue. The Pareto analysis does not provide insights into the potential solutions to solving the issues.

Qualitative Insights

Pareto charts reflect qualitative insights and are not of much use in summing up quantitative solutions. For example, one can easily understand the main issues by observing the graph and line chart. But, finding the mean, standard deviation, or applying other mathematical solutions will not provide any meaningful insight.

Scoring

To be able to find solutions effectively, the scoring of each problem has to be accurate. The decision is sensitive to the scoring of each issue. Improper scoring will identify incorrect problems that have a huge impact; further, the solutions identified will not improve the issues as they should do.

Final Words

Whatever we say, Pareto Principle is an important, critical, and effective tool in the hands of management. It facilitates the identification of problems with their magnitude and thus helps management prioritize the issue resolution. 



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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