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Tuesday, November 1, 2016

Pareto Principle

The Pareto Principle is just that, a principle.  This principle says that, generally, 20% of
the input is responsible for 80% of the outcome.  This is also called the 80/20 rule.

In 1896, Italian economist Vilfredo Pareto reported that he discovered in Italy 80% of all the publicly-owned land in the country was owned by 20% of the population.  Inversely, he observed that 20% of the land was owned by 80% of the population.  It is reported that Pareto noticed in his garden that 20% of the peapods contained 80% of the peas.

Later, a management consultant named Joseph Juran developed the concept a little more formally.

Today, the Pareto Principle is used to note that 80% of results are produced by 20% of the company’s employees. 

This rule of thumb should only be used as just that, a rule of thumb.  It is not cast in stone, nor is it 100% accurate. 

Accuracy aside, let’s take a look at what might happen if someone acted upon the principle.

Let’s say you are in charge of a company that has 10 stores.  Your company’s total profit for the year is $100,000.  You review your data and discover that 80% of your profits came from 20% of your stores.

20% of ten stores is 2 stores.  80% of $100,000 is $80,000.  This means that you had 2 stores that produced approximately $40K each.  That would mean that your remaining stores had an average of $2,500 per store.

Some looking at the data would suggest that the company should close the stores making $2,500 in profit or less per year. 

However, remember that the Pareto Principle is a tool.  This tool should be used to help improve the company.

The proper thing to do in this situation is to analyze the data.  What do the two more profitable stores have in common with each other that is not found in the other locations or is found there but is not as prevalent?

Next, it is time for a little of that Management by Walking Around we talked about. This would be the time for senior management to get into the two more profitable stores and observe them in detail, but not mess with anything.

After observing the two more profitable stores for several days, senior management should get into each of the less profitable stores and observe.

If we remember the Iceberg of Ignorance, we will remember that the line-level employee is typically aware of 100% of the problems within a company, while top-level management is only aware of approximately 4% of the problems faced by the company.

With that in mind, each line-level employee, one at a time, should be sent from the less profitable stores to observe the most profitable stores.  At the same time, line-level employees from the most profitable stores should be sent to observe the less profitable stores.

To determine what, if anything, these line-level employees observed, top management should debrief these employees. 

Knee jerk reactions to the situation are not helpful.  Keeping accurate records and reviewing the information from those records is important.

A salesman wishing to improve his sales should review what data he may have on previous sales calls.  Immediately after any sales call, successful or not, the salesman should record all the details he can recall about the sales call.

In reading How I Raised Myself from Failure to Success in Selling, I learned that the author, Frank Bettger, learned that he closed most of the sales on the first or second call.  Sales calls after the first or second did not yield great results.  Bettger learned to concentrate on the first two sales calls and not pursue the sale any further.

Other sales people have learned that it takes at least five sales calls, in most cases, for them to close a sale.  Reviews of their call records indicate that in many cases they failed to follow through to the fifth or sixth sales calls.

The take away from this is that we really cannot know what the data is telling us without thoroughly analyzing that data in detail and asking why the results are like they are.

Once we know what the data reveals, it is up to management to determine how to act on it.

Imagine, if you will, our store scenario.  What if our data indicates that 80% of our sales and profits come from the PCBs (Packaged Carbonated Beverages)?  One might determine that since this is where most of our sales and profits come from that we should get out of all other product lines and just sell PCBs. 

Now, our manager determines that, in the PCBs, Kooky Kola has 80% of all sales and profits.  Another beverage, Fiza Cola Fit, accounts for 20% of the sales and profits for the store. 

In a world where some managers only see the data and not the big picture, our manager might determine that since most of our profits come from PCBs, we should ONLY sell PCBs.  Then, the manager might determine that since Kooky Kola accounts for most of the sales in the PCB line, the store should ONLY sell Kooky Kola. 

This means we now have a store that has one product, Kooky Kola.  Would you shop there?

Jack Welch’s Differentiation Vitality Curve is based on the Pareto Principle.  See our video about it to see how the principle is applied.

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