dothesums blog

POSITION PAPER – PARETO PRINCIPLE

Most people dream of a concept that, applied to their business and private life, would lift their performance substantially. We all yearn for a method that will bring increased income, career or business growth and personal satisfaction. A tool which generates the most money, with the least expenditure of assets and effort.

There is such a device.

It is not a secret, it has been around in one form or another for the last hundred years, it is naturally occurring and it is not difficult to use.

In the late 19th century the Italian economist Vilfredo Pareto, whilst studying the distribution of wealth and income, discovered a regular relationship. No matter what the economy, the distribution was always heavily skewed towards the top end. That is, a small proportion of the population always accounted for a disproportionately large proportion of the wealth, or income. It turns out that Pareto’s General Principle, that when two sets of data related to causes and results are examined and analysed, there will be a pattern of imbalance, is applicable in many circumstances.

It was not until the middle of the 20th Century that Joseph Juran and later William Deming applied the technique to quality control, that it began to be recognised for its value. Deming in particular, took his ideas from an uninterested USA to Japan and transformed the Japanese economy, known then for its shoddy imitations, into a powerhouse of high quality and efficiency.

The Pareto Principle, alternatively called The 80/20 Rule, states that in any series of elements to be controlled, a small fraction in terms of the number of elements, accounts for a larger fraction in terms of effect.

A small fraction of; Accounts for a large fraction of;

People Wealth and income
Quality characteristics Customer complaints
Parts Delivery delays
Purchase orders Purchase value
Customers Credit losses, unjustified returns
Decisions Total effect of all decisions
Management attention Effect of management
Record maintenance Control of stocks
Time Achievement

The result of using this device is to separate the vital few from the trivial many.

There are two ways of using the 80/20 Principle.

1) 80/20 Analysis which is precise, quantitative, requires investigation, provides facts and is highly valuable.

2) 80/20 Thinking which is fuzzy, quantitative, requires thought, provides insight and is highly valuable.

1) 80/20 Analysis Example

In a small business, only a limited amount of time can be devoted to a selling effort. Three categories of support can be given to this activity.

1) A limited number of visits by the Marketing Director.
2) A more frequent number of visits by a sales representative.
3) A larger number of telephone calls by a sales assistant.

The company has ten existing customers, who have the following sales records:

CUSTOMER OUTLETS AVERAGE ANNUAL SALES PER OUTLET
A 8 £1250
B 18 £450
C 30 £75
D 25 £10
E 3 £280
F 4 £80
G 18 £45
H 7 £250
I 12 £150
J 26 £30

Given central purchasing by the customers, how should we deploy the resources available to us for the maximum effect?

STEP 1

Calculate annual revenue per customer:

CUSTOMER ANNUAL SALES
A 10000
B 8100
C 2250
D 250
E 840
F 320
G 810
H 1750
I 1800
J 780

Sales Revenue for 10 Customers = £26900 total annual sales.

Note that in this simple case, since we have ten customers, or items, each customer will be ten per cent of the total number of customers and therefore the cumulative sum of the two largest customers, or items, will be twenty per cent and so on.

STEP 2

Arrange customers in descending order of total annual sales:

CUSTOMER ANNUAL SALES CUMULATIVE %AGE OF TOTAL SALES
A £10000 37
B £8100 67
C £2250 76
I £1800 82.5
H £1750 89
E £840 92
G £810 95
J £780 98
F £320 99
D £250 100

STEP 3

Compare the cumulative percentage of customers with the relevant cumulative percentage of annual sales thus:

CUSTOMER CUMULATIVE %AGE OF TOTAL NO OF CUSTOMERS ANNUAL
SALES CUMULATIVE %AGE OF TOTAL SALES
A 10 £10000 37
B 20 £8100 67
C 30 £2250 76
I 40 £1800 82.5
H 50 £1750 89
E 60 £840 92
G 70 £810 95
J 80 £780 98
F 90 £320 99
D 100 £250 100

We could now plot a graph with column 2 above as the ‘x’ axis and column 4 above as the ‘y’ axis, which would show the non-linearity of this relationship.

However, we can see by inspection here that two items, or customers, account for two thirds of total sales. Also, that half the customers account for eighty nine per cent of sales and therefore the other half of all customers contribute only eleven per cent of sales.

It might be therefore that we would decide to get our Sales Manager to visit Customers A and B, the Sales Representative to visit customers C, I and H and the telesales Assistant to contact customers E, G, J, F and D.

Now the above data represents only existing sales and we would go on to collect information on say, potential sales. In which case we could well come to a different conclusion.

We can choose what criteria to use depending on what question we want answered and the objective we are trying to meet.

80/20 Thinking is counter-intuitive and eccentric. It does not accept that:

All causes are approximately equal.

All customers are of equal value.

Every piece of business and every pound is of equal value.

Each day or week we spend has the same significance.

All our friends are roughly equal to us.

All opportunities are of approximate equal value.

Fifty per cent of inputs will account for fifty per cent of results or outputs.

The 50/50 fallacy, or the law of averages, is one of the most harmful and destructive rules in our mental maps.

The 80/20 Principle is anti-average.

To summarise the above, the 80/20 principle is a shorthand way (the actual ratio will hardly ever be exactly 80/20, but will have the form major/minor), of saying that when two sets of data related to causes and results are examined and analysed, there will be a pattern of imbalance. And further when we know the true relationship we are likely to be surprised at how unbalanced it is.

The first implication of 80/20 Thinking is the allocation of resources from unproductive use by replacement, which is almost exactly a definition of the role of the entrepreneur.

The second is to make unproductive resources more effective, which is the role of the improver, i.e. doctors, scientists, lecturers, trainers, etc.

The Principle has no ideological overtone, choices can be made for good and bad reasons, it simply seeks to differentiate between:

1) The majority that have little impact and
2) A small minority that have a major, dominant impact.

Because 80/20 analysis uses data, we cannot possibly use it every time we have to make a decision. Life would become impossibly slow. As with 80/20 analysis we start with an hypothesis about a possible imbalance, but instead of collecting data and analysing it, we estimate it. 80/20 Thinking enables us to ask, what is the 20% that is leading to the 80% return? What are the few inputs, or causes that result in a disproportionately large performance?

Some useful habits:

- Celebrate and encourage exceptional productivity, rather than raise average efforts.

- Look for the short cut, rather than run the full course

- Exercise control over our lives with the least possible effort.

- Be selective, not exhaustive.

- Strive for excellence in a few things, rather than a good performance in many.

- Delegate, or outsource as much as possible in our daily lives and be encouraged rather than penalised by tax systems to do this.

- Choose our careers and employers with extraordinary care, and if possible, employ others rather than be employed ourselves.

- Only do the things we are best at doing and enjoy most.

- Look beneath the normal texture of life to uncover ironies and oddities.

- In every important sphere, work out where 20% of effort can lead to 80% of returns.

- Target a number of very valuable goals where the 80/20 principle will work for us, rather than pursuing every available opportunity.

- Make the most of those few lucky streaks in our life where we are at our creative peak.

We commend the Pareto Principle to you and trust that you will be amongst the twenty per cent of the population that reap eighty per cent of the rewards.