Pareto Principle

In 1896 an Italian economist, Vilfredo Pareto, determined that 80% of the wealth in Italy belonged to about 20% of the population. This law shows how a small proportion of a population accounts for a large proportion of consumption, ownership or output.  It is also known as the 80:20 rule.

The concept of unequal distribution in a population is particularly useful in business.  20% of your time produces 80% of your business results; 20% of customers account for 80% of revenue and shows where efforts will have most reward. Such inequality can be taken further. For example, 5% of the population usually accounts for two thirds of consumption, or wealth, or some other characteristic. This unequal distribution is the basis for organising a key account management strategy. The Pareto principle gives us a framework that can be used in all types of business and financial analysis as well as organising work and life.

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The Pareto principle applies to most statistical distributions. 80% of the profit comes from 20% of customers, 80% of product faults are the result of 20% of the most reported bugs in a system. Scatter graphs and histograms are tools for analysing a population to determine how the Pareto principle applies.

We must be careful with this principle because there is a temptation to jettison the tail end of customers who account for very few sales. This may seem to be a perfectly justifiable strategy but first it is worthwhile checking whether some of the small customers have a potential which isn't being tapped at the present. Some of the customers may buy little from you but there could be much more to go for. Some customers may be small but growing fast. Some could be profitable, especially if they are serviced with a light and inexpensive sales touch.

Jack Welsh, the management guru in charge of General Electric between 1981 and 2001, drove the company to greater efficient using the Pareto principle. He described his workforce as reflecting a 20-70-10 system.  By this he meant that the top 20% of the workforce was the most productive, the 70% in the middle worked adequately, and the 10% at the bottom were non-producers and should be fired. With this in mind he culled the bottom 10% of the workforce each year. This improved the quality of the workforce but had serious implications on the morale of those that remained. They knew that they would be in line for similar considerations next year.

Here are several ways the Pareto Principle can be used in businesses:

Identify Key Customers and Products: Analyse customer and product data to identify the top-performing 20%. Focus on key customers who contribute the most to revenue or products that generate the majority of sales. Allocate resources and marketing efforts accordingly.

Sales and Customer Segmentation: Segment customers based on their contribution to revenue. Focus sales efforts on the top 20% of customers who contribute the most to sales, and tailor marketing strategies accordingly.

Customer Service and Satisfaction: Identify the key customer service issues or concerns that contribute the most to customer dissatisfaction. Addressing these issues can lead to a significant improvement in overall customer satisfaction.

Prioritise Marketing Channels: Identify the marketing channels that yield the highest returns. Concentrate efforts on the channels that bring in the majority of leads, conversions, or customer engagement. This helps optimise marketing budgets and strategies.

Employee Productivity: Recognise the high-performing 20% of employees who contribute significantly to the organisation's success. Provide them with additional training, responsibilities, or incentives. Similarly, address any issues with the lower-performing 80%.

Time Management: Analyse time usage and identify the most critical tasks that contribute the most value. Focus on the activities that lead to the greatest impact and results, and consider delegating or automating less critical tasks.

Inventory Management: Apply the Pareto Principle to inventory management by identifying the most critical items that generate the majority of sales. Ensure that these items are well-stocked and readily available to meet customer demand.

Project Management: Evaluate projects and tasks to identify the most critical and impactful elements. Prioritise efforts on the tasks that contribute the most to the project's success and overall business goals.

Product Development: Focus on the key features or attributes that contribute the most to the success of a product. Streamline product development by emphasising the aspects that align with customer preferences and generate the highest satisfaction.

Cost Management: Analyse costs and expenses to identify the major contributors to overall expenditure. Focus on optimising or reducing costs in the areas that have the most significant impact on the bottom line.

Quality Improvement: Identify the root causes of quality issues by focusing on the critical factors that contribute to the majority of problems. Addressing these key issues can lead to substantial improvements in overall product or service quality.

Strategic Planning: Apply the Pareto Principle to strategic planning by identifying the critical factors that contribute the most to achieving business objectives. Allocate resources and efforts strategically to maximise impact.

Some things to think about:

• Consider key aspects of your business such as customer sales, production, employee productivity, and costs. Assemble data on these key aspects and rank the data so that you can see which is having most effect on your business.

  
  

• What will be the implications if you were to prune the "tail" within each of these distributions? For example, would losing some of your smallest customers leads to a greater profitability or could you potentially be losing some that would grow to be much more important?

  
  

• Use the Pareto principle to obtain a greater understanding of what is driving your business. As you build up this greater understanding use it (with care) to make your company more efficient.