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The Pareto Principle And Pareto Analysis In A Nutshell

The Pareto Analysis is a statistical analysis used in business decision making that identifies a certain number of input factors that have the greatest impact on income. It is based on the similarly named Pareto Principle, which states that 80% of the effect of something can be attributed to just 20% of the drivers.

Understanding the Pareto Analysis

The Pareto Analysis was named after Italian economist Vilfredo Pareto, who noted that 80% of the total income earned in Italy went to 20% of the population. In a modern business context, the principle is evident in a variety of settings.

For example:

  • 20% of a product range accounts for 80% of profits.
  • 80% of customer complaints relate to 20% of products or services.
  • 20% of the workforce accounts for 80% of company revenue.
  • 80% of meeting decisions come in 20% of the total meeting time.

Conducting a Pareto Analysis

Although the applications of a Pareto Analysis are vast, certain principles will apply to most situations.

Following is a six-step process that businesses can use.

1. Identify the problems

Start by writing a list of the problems that need resolving.

2. Identify root causes

Then, identify the fundamental cause of each problem. Note that there could be multiple causes of a single problem.

3. Score the problems

In step 3, it is time to score each problem. The scoring method being utilized will depend on the industry and the nature of the problem itself. For example, a business trying to increase profits might score each problem based on how much it is costing them. 

Indeed, cost is a common problem in business. But problems can also be scored based on duration or the number of times they occur in a specified period.

4. Group problems

Group the problems according to the root cause. Perhaps a group is focused on customer satisfaction, while another on quality control.

5. Tally the scores

Now, add the scores for each group. The group with the highest score is the top priority, as it is part of the 20% of factors causing 80% of the problems. Sometimes, two or even three groups may be causing the majority of problems.

6. Action

Lastly, allocate resources to the problems with the highest scores and thus the most potential to impact on profits, customers, or sales.

Advantages of the Pareto Analysis

  • Efficiency. The analysis allows businesses to quickly and accurately identify factors that are contributing to a significant proportion of their problems.
  • Problem-solving ability. Many workplace problems are intangible in the sense that personnel does not agree on their scope or even on their definition. The Pareto Analysis allows people to come to a consensus on the main problems facing an organization. This also increases morale and cohesiveness in the process.
  • Improved decision making. A company that can quantify its main problems is better able to make decisions to counteract them. Quantifiable problems are also better prepared for so that they have less chance of recurring in the future.

Key takeaways

  • Fundamentally, the Pareto Analysis is a statistical technique that identifies a limited number of factors that produce a significant overall effect.
  • The Pareto Analysis has a vast range of applications in business settings, allowing organizations to target problems that erode profits or budget expenditure.
  • The Pareto Analysis is an efficient technique that brings personnel together to quantify and then work to address tangible problems.

Connected Business Concepts

Heuristics

heuristic
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.

Bounded Rationality

bounded-rationality
Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.

Second-Order Thinking

second-order-thinking
Second-order thinking is a means of assessing the implications of our decisions by considering future consequences. Second-order thinking is a mental model that considers all future possibilities. It encourages individuals to think outside of the box so that they can prepare for every and eventuality. It also discourages the tendency for individuals to default to the most obvious choice.

Lateral Thinking

lateral-thinking
Lateral thinking is a business strategy that involves approaching a problem from a different direction. The strategy attempts to remove traditionally formulaic and routine approaches to problem-solving by advocating creative thinking, therefore finding unconventional ways to solve a known problem. This sort of non-linear approach to problem-solving, can at times, create a big impact.

Moonshot Thinking

moonshot-thinking
Moonshot thinking is an approach to innovation, and it can be applied to business or any other discipline where you target at least 10X goals. That shifts the mindset, and it empowers a team of people to look for unconventional solutions, thus starting from first principles, by leveraging on fast-paced experimentation.

Biases

biases
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.

Dunning-Kruger Effect

dunning-kruger-effect
The Dunning-Kruger effect describes a cognitive bias where people with low ability in a task overestimate their ability to perform that task well. Consumers or businesses that do not possess the requisite knowledge make bad decisions. What’s more, knowledge gaps prevent the person or business from seeing their mistakes.

Occam’s Razor

occams-razor
Occam’s Razor states that one should not increase (beyond reason) the number of entities required to explain anything. All things being equal, the simplest solution is often the best one. The principle is attributed to 14th-century English theologian William of Ockham.

Mandela Effect

mandela-effect
The Mandela effect is a phenomenon where a large group of people remembers an event differently from how it occurred. The Mandela effect was first described in relation to Fiona Broome, who believed that former South African President Nelson Mandela died in prison during the 1980s. While Mandela was released from prison in 1990 and died 23 years later, Broome remembered news coverage of his death in prison and even a speech from his widow. Of course, neither event occurred in reality. But Broome was later to discover that she was not the only one with the same recollection of events.

Crowding-Out Effect

crowding-out-effect
The crowding-out effect occurs when public sector spending reduces spending in the private sector.

Bandwagon Effect

bandwagon-effect
The bandwagon effect tells us that the more a belief or idea has been adopted by more people within a group, the more the individual adoption of that idea might increase within the same group. This is the psychological effect that leads to herd mentality. What is marketing can be associated with social proof.

Read Next: BiasesBounded RationalityMandela EffectDunning-Kruger

Read Next: Heuristics, Biases.

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