PARETO PRINCIPLE & ANALYSIS
“20 percent of focused effort results in 80 percent outcome of results!”
– Vilfredo Pareto, 18th Century Italian Economist & Philosopher
I remember the first time I did a Pareto analysis when I was a Business Analyst at Mercer Management Consulting. I was on a cool marketing project to figure out the share of wallet an agrichemical company had with the top 100,000 farmers in the US. My project manager taught me how to do a Pareto analysis, and low and behold the top 20% of farms managed about 80% of the farmland. I was flabbergasted at the awesome chart and insight.
Typically, a Pareto analysis is one of the first analyses I conduct in any new situation. It is excellent for creating a quick and comprehensive fact base on an organization’s costs, sales, customers, products, services, partners, customer service issues, and just about anything else.
As a strategic leader, a lot of your responsibility is to focus the efforts of people and work, and the Pareto principle & analysis should be your go-to analytic tool to support you in your efforts.
What is the Pareto principle?
About your organization, do you know what percentage of:
• …customers make up 80% of the profit?
• …products make up 80% of sales?
• …effort creates 80% of the value?
I’m going to throw out a typically fairly accurate guess. The answer to all of the above questions is about 20%. If you don’t believe me, go do the analysis. If I’m wrong, at least you’ll know the answer.
The Pareto principle phenomenon is that you can often attribute 80% of something to 20% of a population or set of inputs. The Pareto principle was first observed by Vilfredo Pareto, a 19th Century Italian economist, who discovered that 20% of the population owned 80% of the land in Italy, and also, in his garden, just 20% of the peapods accounted for 80% of the harvested peas.
The Pareto principle has since become an important principle in business since it is a simple and natural forcing function to prioritize effort. You should prioritize the 20 % of customers who make up 80% of your profits. You should focus on improving the 20 % of products that make up 80% of your sales. You should better understand the 20% of effort that typically creates 80% of the value in a project.
Pareto analysis is one of the most basic and useful analytic tools. It is simply rank-ordering costs, sales, productivity, or other metrics and attributing a % of the cumulative value at each ranking of the total. Below is a simplified example of a Pareto analysis of the costs of 10 items.
If you were trying to reduce costs, you would probably focus on the first two items. Below is an example of the same data in a Pareto chart, mapping out % of the total vs. % of the number of cost items.
How do you create a Pareto analysis?
Almost anything can be analyzed using Pareto analysis, including costs, quality issues, sales by customer, product or salesperson, profitability by customer or channel, and advertising effectiveness, along with hundreds of other data sets across the organization. Here is the recipe for doing a Pareto analysis.
The Actual Pareto Calculation
While Pareto analysis isn’t too difficult, it is good to go through it step by step.
o Step 1 – Rank order the values of a list
o Step 2 – Create a running cardinal value ranking of the list (1, 2, 3…)
o Step 3 – Create another column and calculate the running percentage of the cardinal values
o Step 4 – Create another column and calculate the running total of the values
o Step 5 – Create another column and calculate the running percentage of the cardinal values
Each of the top items (the items that make up the 20% with the 80% impact) can usually be turned into a second-level Pareto chart. For instance, in the above example, item 1 may consist of several colors (red, yellow, green, purple, blue, and pink). By creating a second-level Pareto chart, we can further stratify the data and learn that the top sellers are red (40%), green (30%), and blue (15%). We now have converted data to information so we can start a discussion around the top colors versus the other colored products.
Use it as a Forcing Function for Focus
With projects and products, I always use the Pareto principle to focus teams to prioritize and work on the 20% of important elements that will drive 80% of the value of the project or product. In some organizations, we even made Pareto into a verb…” Let’s Pareto this….”.
DOWNLOAD THE PARETO EXCEL WORKSHEET
To get you going on creating a Pareto analysis, download the free and editable Pareto Analysis Excel Worksheet.