What is Pareto Principle?
The Pareto Principle is named after a famous Italian economist Vilfredo Pareto. The first time this principle was noted when he looked at the economic state of the Italian Population. He found that 80% of the wealth in Italy was owned by 20% of the people. This survey was then carried out in several other countries where the results showed a similar distribution.
The Pareto Principle often used for making business and quality control decisions. It is used for prioritization of a few important elements amongst many.
The Pareto Principle is also known as 80/20 rule. This is because in most situations 80% of the outcome is driven by 20% of the causes (“vital few”).
For example, In the US, it was noted that 80% of the taxes were paid by 20% of earning population. In several businesses, 80% of the sales come from 20% of the customers. In such a case, the business can focus more on these 20% customers and reward them for their loyalty.
The 80/20 rule is also applied by consulting companies in client projects for improving productivity, time management and customer satisfaction. Usually, 80% of the problems in context can be solved by focusing on 20% of the issues.
What is a Pareto Chart ?
A Pareto chart is a graphical representation of the Pareto Principle. It is a combo Bar and a Line chart. The Bar shows the individual contribution of each element in a descending order and the line shows the cumulative percentage of all elements. This chart helps focus on “vital few” elements for improvements.
Pareto analysis helps us focus on the key problem areas rather than boiling the whole ocean. Here is a simple example.
A restaurant conducted a survey with its customers who visited it in past few months. The management wanted to understand what customers thought and reasons for its falling sales. The survey was conducted with 1000+ customers. The feedback given around multiple improvement levers which were categorized in 8 broad heads (shown below).
The management wanted to focus on each of these issues
separately. As a consultant you are asked to advice on how tackle the
You can do a simple but effective Pareto analysis to help the management understand the critical issues that the customers faced. This can be done in 3 steps.
Sign up for Financial analyst course online to improve financial analysis skills
Step 1 – Arrange the data in descending order.
Data > Sort > Largest to Smallest
Step 2- Calculate the cumulative percentage of Customer Complaints.
Once you have sorted the data in descending order, insert two columns. One for calculating the cumulative number of customer complaints and other to calculate the cumulative percent of customer complaints (as shown below).
Step 3 – Insert a Combo/Pareto chart
To insert a chart, press the control key and select the chart data (the first, second and fourth column here).
Now go to insert, and in the chart section click on the recommended charts and then on All Charts.
From the chart list, select combo chart.
We see that the # customer complaints are a clustered column
chart and the Cumulative percent is a line chart.
We will now click on the secondary axis for the cumulative
percent (%). Then we get the following chart.
We will now give the chart a title and remove the chart border. To remove the chart border, click on the chart, then go to format and click on shape outline. If you don’t need the border, then choose No outline.
Now add data labels to the number of customer complaints and the cumulative percent. To get the data labels, click on the column and then right click and select Add data labels. Similarly, click on the cumulative percent (%), then right click and select Add data labels.
Now to show the Pareto analysis, draw a line at 80% on the
secondary y-axis to the point where it intersects the cumulative percent
series. From the intersection point draw another line vertically and connect it
to the x-axis (as shown below).
The above analysis shows, that 80% plus customer complaints can be resolved by focusing on just 2 issues. Price and Serving size. Rather than focusing on all the issues, if the restaurant focusses on the 2 big issues (“vital few”), it can reduce the customer complaints by more than 80%.
Keep learning and have fun.
Please Log in for comments.