Sunday, 13 December 2009

Pareto analysis

The Pareto principle, also known as the 80:20 rule, says that 20% of the input produces 80% of the output. It can be applied in a wide variety of strategic analyses.

The most common application is that 20% of a business' clients produce 80% of the profits. See Your company's making money, but are you? for example. Closely related to this is that 20% of a business' products/lines produce 80% of the profits. But other applications can also add significant value. For example, in The Good Enough Revolution: When Cheap and Simple is just fine, Wired Magazine suggests that customers may attribute 80% of the value of a product to 20% of its features. The suggest, for example, that since most customers of Microsoft's Office programmes use only 20% of the product's features, they are increasingly turning to less fully featured office solutions, such as Google Documents, which offer fewer features, but other advantages.

Of course, 80:20 is just a figure of speech - the numbers could be anything. They don't even need to add up to 100%, and neither are the limited by 100%. So, it could be that 15% of the products produce 110% of the profits. In this example, it follows that the remaining 85% of products contribute a 10% loss (bringing the combined profit back down to 100%).

Pareto analysis involves identifying and attributing the value created (the outputs) to the inputs. It is often charted in the following manner:

Pareto Chart
Good Pareto analysis relies on a cost accounting system, such as an Activity-Based Costing (ABC) system for data, in order to achieve this attribution.

Pareto analysis can help a firm make decisions about where to apply resources and focus. It is particularly useful in identify loss leaders, which may then be exited if they have low strategic value, or remediated if they have greater strategic value. I am often told that loss leaders must be sustained simply because they contribute to overhead and fixed costs, but this logic does not stand up if you consider that all costs are variable in the long run. However, loss leaders may make sense where they attract customers who subsequently buy more profitable products. It is also useful for firms that have lost direction and are looking for a focal point around which to reposition themselves in the market.

Pareto charts, like the one shown above, can be difficult to draw. They are not easily supported by common charting tools like those bundled into MS-Excel. Fortunately, StratNavApp.com, the free, innovative and collaborative strategy tool can help you draw Pareto charts - the one above was drawn in StratNavApp.com. Why not try it now?

See also: 6 essential strategy analysis tools (The Pareto principle is named after Vilfredo Pareto who observed in 1906 that 80% of the land in Italy was owned by 20% of the population.)