pareto-principle-pareto-analysis

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 Frameworks

first-principles-thinking
First-principles thinking – sometimes called reasoning from first principles – is used to reverse-engineer complex problems and encourage creativity. It involves breaking down problems into basic elements and reassembling them from the ground up. Elon Musk is among the strongest proponents of this way of thinking.
ladder-of-inference
The ladder of inference is a conscious or subconscious thinking process where an individual moves from a fact to a decision or action. The ladder of inference was created by academic Chris Argyris to illustrate how people form and then use mental models to make decisions.
six-thinking-hats-model
The Six Thinking Hats model was created by psychologist Edward de Bono in 1986, who noted that personality type was a key driver of how people approached problem-solving. For example, optimists view situations differently from pessimists. Analytical individuals may generate ideas that a more emotional person would not, and vice versa.
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 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 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.
design-thinking
Tim Brown, Executive Chair of IDEO, defined design thinking as “a human-centered approach to innovation that draws from the designer’s toolkit to integrate the needs of people, the possibilities of technology, and the requirements for business success.” Therefore, desirability, feasibility, and viability are balanced to solve critical problems.

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Published by

Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which reached over a million business students, executives, and aspiring entrepreneurs in 2020 alone | He is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate | Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy | Visit The FourWeekMBA BizSchool | Or Get The FourWeekMBA Flagship Book "100+ Business Models"