What Is Pareto Analysis?
Pareto analysis is a technique used for business decision-making, but which also has applications in several different fields from welfare economics to quality control. It is based largely on the "80-20 rule." As a decision-making technique, Pareto analysis statistically separates a limited number of input factors—either desirable or undesirable—which have the greatest impact on an outcome.
Pareto analysis is premised on the idea that 80% of a project's benefit can be achieved by doing 20% of the work—or, conversely, 80% of problems can be traced to 20% of the causes. Pareto analysis is a powerful quality and decision-making tool. In the most general sense, it is a technique for getting the necessary facts needed for setting priorities.
- As a decision-making technique, Pareto analysis statistically separates a limited number of input factors—either desirable or undesirable—which have the greatest impact on an outcome.
- Pareto analysis states that 80% of a project's benefit or results are achieved from 20% of the work—or conversely, 80% of problems can be traced to 20% of the causes.
- With Pareto analysis, each problem or benefit is given a numerical score based on the level of impact on the company; the higher the score, the greater its impact.
- Modern-day applications of Pareto analysis are used to determine which issues cause the most problems within various different departments, organizations, or sectors of a business.
- By allocating resources to issues with higher scores, companies can use Pareto analysis to solve problems more efficiently because they can target those problems that have a greater impact on the business.
Understanding Pareto Analysis
In 1906, Italian economist Vilfredo Pareto discovered that 80% of the land in Italy was owned by just 20% of the people in the country. He extended his research and determined that this disproportionate wealth distribution was the same across all of Europe. The 80-20 rule was formally defined as follows: The top 20% of a country’s population accounts for an estimated 80% of the country’s wealth or total income.
Joseph Juran, a Romanian-American business theorist, discovered Pareto’s research in 1937, approximately 40 years after it was published. Juran proceeded to rename the 80-20 rule as "Pareto’s Principle of Unequal Distribution."
Juran extended Pareto’s principle to the business world in order to understand whether the rule could be applied to problems faced by businesses. He observed that in quality control departments, most production defects resulted from a small percentage of the causes of all defects. So, by extension, 80% of the problems are caused by 20% of the defects; the implications of Juran's work are that if you focus on fixing that 20%, you could have a big impact with minimal effort.
Joseph Juran, a Romanian-American engineer and management consultant, coined the terms “vital few,” “useful many,” and “trivial many” to refer to the few contributions that account for the bulk of the effect, and to the many other contributions that account for a smaller proportion of the effect.
Modern-day applications of Pareto analysis are used to determine which issues cause the most problems within different departments, organizations, or sectors of a business.
Typically, Pareto analysis is employed by business managers, whose approach typically involves conducting a statistical analysis, such as a cause and effect analysis, to produce a list of potential problems and the outcomes of these problems. Following the information provided by the cause and effect analysis, the 80-20 rule can be applied. Here are some scenarios relevant to businesses where Pareto analysis might be applicable:
- Sharing information about defects/errors with high priority stakeholders
- Prioritizing defects or tasks according to their severity, i.e. according to their impact on a system or business
- Analyzing data or errors/defects
Steps of Pareto Analysis
By applying the 80-20 rule, problems can be sorted based on whether they affect profits, customer complaints, technical issues, product defects, or delays and backlogs from missed deadlines. Each of these issues is given a rating based on the amount of revenue or sales, and time lost, or the number of complaints received. Here is a basic breakdown of the steps of Pareto analysis:
- Identify the problem or problems
- List or identify the cause of the issues or problems, noting that there could be multiple causes
- Score the problems by assigning a number to each one that prioritizes the problem based on the level of negative impact on the company
- Organize the problems into groups, such as customer service or system issues
- Develop and implement an action plan, focusing on the higher scored problems first, in order to solve the problems
Not all problems will have a high score, and some smaller problems may not be worth pursuing initially. By allocating resources to high-impact issues or higher scores, companies can solve problems more efficiently by targeting the issues that have a major impact on profits, sales, or customers.
Pareto analysis shows that a disproportionate improvement can be achieved by ranking various causes of a problem and concentrating on the solutions with the largest impact.
Advantages and Disadvantages of Pareto Analysis
In the most general sense, the advantage of Pareto analysis is that it helps to identify and determine the root causes of defects or problems. Because of this, businesses are able to eliminate or resolve defects or errors with the highest priority first.
Pareto charts can specifically help determine the cumulative impact of a problem. Cumulative impact results from effects caused by a problem happening over a long period of time. Pareto charts are especially useful for businesses or organizations because they can use them to plan the measures or actions that need to be taken in order to amend the problems. For this reason, Pareto charts can sharpen problem-solving and decision-making skills: problems related to a defect or error can be distilled into cohesive facts.
The main disadvantage of Pareto analysis is that it does not provide solutions to issues; it is only helpful for determining or identifying the root causes of a problem(s). In addition, Pareto analysis only focuses on past data. While information about past errors or problems is useful, it's not a guarantee that it will be relevant in future scenarios.
A final disadvantage of Pareto charts is that they can only show qualitative data that can be observed; they cannot be used to represent quantitative data. For example, Pareto charts cannot be used to calculate the mean, the standard deviation, or the average of the data, its variability, or changes in the measured attribute over time.
Helps to identify and determine the root causes of defects or problems
Organizations can eliminate or resolve defects or errors with the highest priority first
Determine the cumulative impact of a problem, where cumulative impact is defined as an effect that is being caused due to a problem happening over a long period of time
Organizations can use Pareto charts to plan what measures or actions need to be taken in order to amend problems
Pareto charts can sharpen problem-solving and decision-making skills
Does not provide solutions to issues; only helpful for determining or identifying the root causes of a problem(s)
Only focuses on past data
Pareto charts can only show qualitative data that can be observed; they cannot be used to represent quantitative data
Example of Pareto Analysis
Let's say a company discovers a recent increase in product returns from its online retail clothing website. Since the number of returns is above a certain threshold, the company's analysts begin researching and tracking the causes. The main cause appears to be a technical glitch with the website that inaccurately communicates the clothing size selected by online shoppers across several departments.
The secondary issue is a poor customer service experience, resulting in shoppers opting for a refund instead of an exchange for the correct sized clothing. Since the issues translate to lost revenue for the firm, the analysts score the following issues based on the amount of revenue loss attributed to each issue: technical glitch, poor customer service, and lost clients in the long term.
A Pareto chart can be used to identify the problem faced by the firm. A Pareto chart is a type of chart that contains both bars and a line graph, where individual values are represented in descending order by bars, and the cumulative total is represented by the line. The major problems are represented in descending order of their frequency (number of times of occurrence) and their cumulative impact. The chart may have the registered issue as "High Returns From Online Portal." The list of the causes will be shown on the chart with a rating or score beside each cause.
For example, the technical glitch, on a scale of 1 to 10, will be given a 10 and identified as the root cause of the problem and the major factor of lost revenue.
The poor customer service experienced by the shoppers may be attributed to the fact that the customer service representatives were only privy to the wrong information communicated to them (as a result of the glitch). Therefore, while a client was insistent that a size large shirt was purchased, the representative might have been confident that the customer was in error and that the shirt ordered was a size small, leading to dissatisfaction and frustration for the customer.
Given this analysis, the customer service factor might be rated 5 in the hopes that once the glitch is resolved, the information that flows to the customer service representatives will be consistent with the customers' feedback. The lost revenue brought on by losing customers not only in the short-term but even after the glitch is fixed may lead to a score of 8 for this category on the Pareto chart. Groups with the top scores on the chart will be given the highest priority, while the groups with the lowest scores will have the lowest priority.
The online retail store might employ various strategies to win back its lost customers and increase sales. For example, the company could run sales campaigns for its clothing to boost new sales and offer rebates or discounts to dissatisfied customers from the glitch to win the trust of existing customers.
It's important to note that Pareto analysis does not provide solutions to issues, but only helps businesses to identify and narrow down the most significant causes of the majority of their problems. Once the causes have been identified, the company must then create strategies to address those problems.
Pareto analysis will typically show that a disproportionate improvement can be achieved by ranking various causes of a problem and by concentrating on those solutions or items with the largest impact. The basic premise is that not all inputs have the same or even proportional impact on a given output. This type of decision-making can be used in many fields of endeavor, from government policy to individual business decisions.
How Is a Pareto Chart Different From a Standard Vertical Bar Graph?
A vertical bar graph is a type of graph that visually displays data using vertical bars going up from the bottom. In a vertical bar graph, the lengths are proportional to the quantities they represent. Vertical bar graphs are typically utilized when one axis cannot have a numerical scale.
A Pareto chart is a type of chart that contains both bars and a line graph, where individual values are represented in descending order by bars, and the cumulative total is represented by the line. A Pareto chart is different from a vertical bar graph because the bars are positioned in order of decreasing height, with the tallest bar on the left.
How Do You Make a Pareto Chart?
A Pareto chart organizes and displays information to show the relative importance of various problems or causes of problems. It is similar to a vertical bar graph in that it puts items in order (from the highest to the lowest) relative to some measurable effect of interest: frequency, cost, or time.
Here is one method for creating a Pareto chart:
- Develop a list of problems to be compared.
- Develop a standard measure for comparing the items. For example, how often it occurs: frequency (e.g., utilization, complications, errors); how long it takes (time); how many resources it uses (cost).
- Choose a timeframe for collecting the data.
- For each item, tally how often it occurred (or cost or total time). Then, add these amounts to determine the grand total for all items.
- Find the percent of each item in the grand total by taking the sum of the item, dividing it by the grand total, and multiplying by 100.
- List the items being compared in decreasing order of the measure of comparison: e.g., the most frequent to the least frequent. The cumulative percent for an item is the sum of that item’s percent of the total and that of all the other items that come before it in the ordering by rank.
- List the items on the horizontal axis of a graph from highest to lowest. Label the left vertical axis with the numbers (frequency, time, or cost).
- Label the right vertical axis with the cumulative percentages (the cumulative total should equal 100%).
- Draw in the bars for each item.
- Draw a line graph of the cumulative percentages. The first point on the line graph should line up with the top of the first bar.
The final step is analysis. You can analyze a Pareto chart by identifying those items that appear to account for most of the difficulty. One method for doing this is to identify a clear breakpoint in the line graph. (A breakpoint is where it starts to level off quickly.)
If there is no breakpoint, identify the items that account for 50% or more of the effect. If there appears to be no pattern (i.e. the bars are essentially all of the same height), think of some factors that may affect the outcome. At this point, you might decide to divide the data and draw separate Pareto charts for each subgroup to see if a pattern emerges.
What Is Pareto Efficiency?
Pareto efficiency is a state of the economy where resources cannot be reallocated to provide more advantages for one individual without making at least one individual worse off. Pareto efficiency implies that resources are allocated in the most economically efficient manner. However, this state does not guarantee equality or fairness.