What is a Pareto used for? What is 80-20 rule Pareto Analysis?

In today’s dynamic and turbulent environment, it is not feasible or prudent to cover all the bases when one can easily get the maximum output from minimal input. We need to stress being smart rather than a hard worker because he often exhausts himself over activities that do not benefit the customers. Still, now the bulk and volume of transactions have increased manifolds and it is impossible to give importance to every one of them. Because of this reason, a smarter technique was developed to address this major concern.

Did you know? Pareto Analysis is a technique developed by the Italian economist Vilfredo Pareto in the 1960s.

What is Pareto Analysis?

Pareto Analysis is based on the 80/20 rule and aims to segregate inputs so that the cumulative inputs that majorly impact the output can be identified. Pareto Analysis enables us to assess the problems and measure the impact of fixing those problems. It is one of the greatest tools available to help us prioritise the areas, tasks or processes that have the greatest impact.

What is the 80/20 Rule?

The premise of the pareto analysis is based on the principle, commonly denoted as the 80/20 Rule. The rule states that 80% of the output is derived from 20% of the input. In order words, only 20% of work must be done to obtain an 80% result. This rule applies to problems wherein 80% of the problems can be traced back to only 20% of the causes.

Steps of Pareto Analysis

To successfully apply the technique of Pareto Analysis, one must be aware of the various steps concerned with it to gain the maximum benefits.

1. Identify the problems: 

To apply Pareto Analysis, one must first recognize the area or task that needs to be applied. After the area or task is decided upon, one must identify and list all the concerns, issues or problems that need resolution.

2. Determine the cause: 

The root cause of all the problems needs to be assessed and determined. One can use effective tools like Root Cause Analysis or Cause and Effect Analysis to obtain results.

3. Rate those causes: 

Once all the root causes have been determined and listed, they should be rated based on their importance. The rating method largely depends upon the problem that is being resolved. For example, if the agenda is to improve customer satisfaction, the problems should be rated based on the number of customer complaints received.

4. Classify the causes: 

The problems with a similar root cause must be classified into one group.

5. Add up the rate of each group: 

After classification, the rate of each group must be added. The group with the highest rating should be your top priority, and the one with the lowest rating is the one you need to be least concerned about.

After identifying the group with the highest priority, a course of action should be decidedso that the problems associated with that group can be assessed, worked upon and consequently elevated. Regardless, this group would provide the maximum payoff.

5. Take Action

Example of Pareto Analysis

Let us take an example of a spectacle manufacturing company to understand the application of Pareto Analysis.

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We need to first arrange all these problems on the basis of highest frequencies.

It is apparent from the above example that the top three defects- Scratches on the surface, rough edges on lenses and non-uniform grinding of lenses constitute 80% of instances. This means they are the most common ones and should be prioritized more because they are responsible for 80% of the problems.

Pareto Analysis as a Management Tool.

Pareto Analysis is an excellent management tool because it helps establish priorities and identify areas of focus on the vital few. It uses the law of diminishing returns and picks out the low-hanging fruit first. It ensures a higher payoff with minimal work by ranking the tasks or areas accordingly. When combined with analytical tools like Run Charts, Fishbone diagrams, Fault Tree Analysis or Scatter Diagrams, Pareto Analysis proves to be unbeatable at identifying critical areas.

Business Functions following the Pareto Principle

• 20% of customers are responsible for 80% of revenue
• 20% of products incur 80% production costs.
• 20% of suppliers provide 80% of raw materials
• 20% of products generate 80% of profits
• 20% processes add 80% value

It must be noted that the 80/20 rule is flexible, and the proportion could vary. It could be 90/10 or 70/30, and the only logic behind it is that only a few issues need to be addressed to obtain a major result.

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Applications of Pareto Analysis

Pareto Analysis is a simple decision-making technique that can help you to assess and prioritize different problems or tasks by comparing the benefits. Here is a list of application for Pareto Analysis and they are as follows:

1. Product Pricing

 When a company manufactures many products, Pareto Analysis could be used to determine the prices of the products. It can indicate the 20% products that form 80% of sales volume, and the top management could segregate the vital few and the trivial many and accordingly fix their prices.

2. Customer Profitability Analysis

Not all customers generate equal value for the company; some customers are considerably more profitable than others. Pareto Analysis could help identify those 20% of customers that generate 80% profitability, and the company could work to maintain better relations with them.

3. Stock Control

Only a few stock goods make up most of their value. The 80/20 rule lets the businesses identify 20% stock items with 80% value. This enables businesses to control stocks with the most monetary investment.

4. Quality Control

This analysis identifies those defects that receive the most customer complaints. By doing this, the management can ensure better customer satisfaction.

There are many more uses of Pareto Analysis depending on the type of industry and the business model.

Advantages of Using Pareto Analysis

1. Root causes of problems can be identified.
2. Pareto charts help decision-making by providing a birds-eye view of the entire scenario.
3. The cumulative impact of a problem could be assessed, analysed and elevated.
4. Businesses can prioritise their problems and pay more attention to the ones that have the major impact.
5. Pareto Analysis ensures the optimum use of scarce resources.
6. Bigger problems are broken down into smaller parts, making dealing with them significantly easier.
7. Pareto Analysis acts as a control mechanism for resolving defects.

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 Limitations of Pareto Analysis.

1. Pareto Analysis only helps identify the problems and stays silent in providing the appropriate solutions for the identified problems.
2. Pareto Analysis is historic and only works upon past data.
3. It is qualitative and not quantitative.
4. Important problems that are smaller now could possibly be neglected and be bigger later.
5. Causes could be identified incorrectly, and this could shake the whole analysis.

Conclusion

Despite some obvious limitations, Pareto analysis is still a very important tool because present-day businesses deal with many problems, and it is not advisable or even practical to pay attention to each one. Prioritising these problems is, therefore, very important to an effective and efficient business functioning. In early times, businesses were smaller, and it was possible to give importance to each process.

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