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What is the 'Pareto Principle'

The Pareto Principle, named after economist Vilfredo Pareto, specifies that 80 percent of consequences come from 20 percent of the causes, or an unequal relationship between inputs and outputs. This principle serves as a general reminder that the relationship between inputs and outputs is not balanced. The Pareto Principle is also known as the Pareto Rule or the 80/20 Rule. 

BREAKING DOWN 'Pareto Principle'

The original observation of the Pareto Principle was linked to the relationship between wealth and population. According to what Pareto observed, 80 percent of the land in Italy was owned by 20 percent of the population. After surveying a number of other countries, he found the same applied abroad. 

For the most part, the Pareto Principle is an observation that things in life are not always distributed evenly. For instance, the efforts of 20 percent of a corporation's staff could drive 80 percent of the firm's profits. In terms of personal time management, 80 percent of your work-related output could come from only 20 percent of your time at work. In Pareto's case, he used the rule to explain how 80 percent of the wealth is controlled by 20 percent of the country's population.

Why Is the Pareto Principle So Important?

There is a practical reason for applying the Pareto Principle. Simply, it can give you a window into who to reward or what to fix. For example, if 20 percent of the kinks are leading to 80 percent of the crashes, you can identify and fix those kinks. Similarly, if 20 percent of your customers are driving 80 percent of your sales, you may want to focus on those customers and reward them for their loyalty. 

Example of the Pareto Principle in Real Life

The Pareto Principle can be applied in a wide range of areas such as manufacturing, management and human resources. It has been adopted by a variety of coaching and customer relationship management (CRM) software programs. A financial advisory business commonly uses the Pareto Principle to help manage its clients. The business is dependent on the advisor’s ability to provide excellent customer service, as its fees rely on its customers’ satisfaction. However, not every client provides the same amount of income to the advisor. If an advisory practice has 100 clients, according to the Pareto Principle, 80 percent of the financial advisor’s revenue should come from the top 20 clients. These 20 clients have the highest amount of assets and the highest fees charged.

The Pareto Principle seems simple but is hard to implement for the typical financial advisor. The principle suggests that since 20 clients are paying 80 percent of the total fees, they should receive at least 80 percent of the customer service. Advisors should spend most of their time cultivating the relationships of their top 20 clients. However, as human nature suggests, this does not happen. Most advisors tend to spread out their time and services without regard to a client’s status. If a client calls and has an issue, the advisor deals accordingly, regardless of how much income the client actually brings in to the advisor.

Advisory practices that have adopted the Pareto Principle have seen improvement in time management, productivity and overall client satisfaction. The principle has also led to advisors focusing on replicating their top 20 percent of clients, knowing that adding a client of that size immediately affects the bottom line.

The Pareto Principle can be applied to many businesses, especially those that are client-service based. It can also be applied on a personal level. Time management is the most common use for the Pareto Principle, as most people tend to thinly spread out their time instead of focusing on the most important tasks.

Problems With the Pareto Principle

While the 80/20 split is true for Pareto's observation, that doesn't necessarily mean that it always has to equal 100. For instance, 30 percent of the workforce (or 30 out of 100 workers) may only complete 60 percent of the output. The remaining workers may not be as productive or may just slacking off on the job. This further reiterates that the Pareto Principle is merely an observation and not necessarily a law. 

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