What Is a Pareto Analysis?
Pareto Analysis is a technique used for business decision making based on the 80/20 rule. It is a decision-making technique that statistically separates a limited number of input factors as having the greatest impact on an outcome, either desirable or undesirable.
Pareto analysis is based on the idea that 80% of a project's benefit can be achieved by doing 20% of the work or conversely 80% of problems are traced to 20% of the causes.
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 this research and found out that the disproportionate wealth distribution was also the same across all of Europe. The 80/20 rule was formally defined as the rule that 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, stumbled on Pareto’s research work 40 years after it was published, and named the 80/20 rule Pareto’s Principle of Unequal Distribution. Juran extended Pareto’s Principle in business situations 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, a phenomenon which he described as "the vital few and the trivial many."
Following the work of Pareto and Juran, the British NHS Institute for Innovation and Improvement provided that 80% of innovations come from 20% of the staff; 80% of the decisions made in meetings come from 20% of the meeting time; 80% of your success comes from 20% of your efforts; and 80% of complaints you make are from 20% of your services.
Today, Pareto Analysis is employed by business managers in all industries to determine which issues cause the most problems within their departments, organizations, or sectors. A good approach typically involves conducting a statistical technique, such as a cause and effect analysis, to produce a list of potential problems and the outcomes of these problems. Following the information provided from the cause and effect analysis, the 80/20 analysis can be applied.
- Pareto analysis states that 80% of a project's benefit or results are achieved from 20% of the work, or conversely, 80% of problems are traced to 20% of the causes.
- Each problem or benefit is given a numerical score based on the level of impact on the company. The higher the score, the greater the impact.
- By allocating resources to the issues with higher scores, companies can solve problems more efficiently by targeting those having a higher impact on the business.
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. A basic breakdown of the steps could involve:
- 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 the action plan to solve the problems by focusing on the higher scored problems first
Not all problems will have a high score, and some smaller problems may not be worth pursuing initially. By allocating resources to the 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 its 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.
Example of Pareto Analysis
A company may discover 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 the 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 and graph can be used to identify the problem faced by the firm. The chart may have the registered issue "high returns from its 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 representatives were only privy to the wrong information communicated to them due to the glitch. Therefore, while a client was insistent that a size L shirt was purchased, the representative might have been confident that the customer was in error and that the shirt ordered was a size S, 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 reps will be consistent with the customers' feedback. The lost revenue brought on by not only losing customers 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 or graph. 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.
It's important to note that Pareto analysis does not provide solutions to issues, but only helps businesses to identify the few significant causes of the majority of their problems. Once the causes have been identified, the company can create strategies to address the problems. It is believed that with Pareto Analysis, 20% of the problems once remedied, can improve a company's outcomes by 80%.
The online retail store might employ a strategy to win back its lost customers and increase sales. 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.
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.