Pareto principle

What it means

The Pareto principle, also known as the 80/20 rule, states that roughly 80 per cent of results come from 20 per cent of causes. For example, most revenue comes from a minority of customers, most complaints from a handful of faults, and most time goes on a few problematic tasks.

The 80/20 ratio is not a law of nature but an empirical observation. In a particular company it may come out as 70/30 or 90/10. What matters is the insight that causes are not equally important and effort is best focused where it achieves most.

The principle underlies ABC analysis, which groups inventory, customers or suppliers by importance, and the Pareto chart, which ranks the causes of a problem from the most frequent. It is a standard tool of lean and quality management methods.

How it works in practice

When analysing client profitability we rank customers by revenue and margin. It often turns out that a small group generates most of the profit while many small customers take up a disproportionate amount of time. That leads to decisions on prices, minimum orders or simplifying the service.

In the subledger and debt collection we focus first on the few customers who account for most of the amount owed. With inventory we likewise track the items that tie up most cash and propose tighter control for them than for small materials.

In problem-solving we combine Pareto analysis with root cause analysis. First we find which faults occur most often, then we look for their real cause. That way the team’s capacity is not spent on rare exceptions.

What to watch out for

The principle does not mean the remaining 80 per cent of causes can be ignored. A small customer may matter for future growth, and a rare error may have serious consequences, for example in safety or tax. Pareto analysis helps set priorities, not strike out everything else.

The result depends on what is measured. Ranking customers by revenue gives a different picture from ranking them by profit or by hours worked. Before any analysis we therefore agree the right metric with whoever commissioned it.