Pareto Analysis

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.

BREAKING DOWN '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 comes from 20% of the staff; 80% of decisions made in meetings comes from 20% of the meeting time; 80% of your success comes from 20% of your efforts; 80% of complaints you make are from 20% of your services; etc.

Today, Pareto Analysis is employed by business managers in all industries who try to determine which issues are causing the most problems within their departments, organizations, or sectors. To identify these issues, a good approach is to conduct 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.

80/20 Rule Examples

Using the 80/20 rule, the 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 are given a rating based on the amount of sales and time lost, or the number of complaints received. For example, a company may discover a recent high level of product return from its online retail clothing platform. Since this number is above a certain threshold, the team runs some research to track the causes. The main cause seems to be a technical bug on the site that wrongly communicates the clothing size selected by the online shoppers across the departments. Coupled with the poor customer service experience, shoppers elect to receive a refund instead of an exchange. Since this translates to lost revenue for the firm, the analysts will score the following issues based on the level of sales loss attributed to each: technical glitch, poor customer service, and lost clients in the long-term.

A Pareto chart and graph will be used to conclude the Pareto analysis to identifies 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 is insistent that he purchased a size L shirt, the agent might be confident that it was a size S that was ordered, leading to dissatisfaction and frustration on the customer’s part. 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. Using the scores on the chart, groups with the top scores will be given highest priority, while the lowest priority will be stamped on the categories with the lowest scores.

Running all the information provided using the chart, it is important to understand that Pareto analysis does not provide solutions to issues, but only helps businesses to identify the few significant causes of majority of their problems. Once the causes have been identified, the company can create strategies and plans in place to address the problems. It is believed that with Pareto Analysis, 20% of the problems once attended to, can improve a business’ outcomes by 80%. Using the online retail store example above, to win back its lost customers and drive up sales, the firm may actually decide to run attractive sales campaigns on its clothing to win the trust and wallets of its patrons.

In its simplest terms, 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.