Pareto Analysis (ABC Analysis)

In 1906, an Italian economist Vilfredo Pareto, observed that 80% of the land in Italy was owned by 20% of the population; he developed the principle by observing that 20% of the pea pods in his garden contained 80% of the peas.

Based on this philosophy, Business-management consultant Joseph M. Juran, define the Pareto Principle (also known as the 80-20 rule, the law of the vital few, and the principle of factor sparsity), that, for many events, roughly 80% of the effects come from 20% of the causes.

It is a common rule of thumb in business; e.g., "80% of your sales come from 20% of your clients". Mathematically, where something is shared among a sufficiently large set of participants, there must be a number k between 50 and 100 such that "k% is taken by (100 − k)% of the participants". The number k may vary from 50 (in the case of equal distribution, i.e. 100% of the population have equal shares) to nearly 100 (when a tiny number of participants account for almost all of the resource). There is nothing special about the number 80% mathematically, but many real systems have k somewhere around this region of intermediate imbalance in distribution.

In business the following trend are observed -

·         80% of your profits come from 20% of your customers

·         80% of your complaints come from 20% of your customers

·         80% of your profits come from 20% of the time you spend

·         80% of your sales come from 20% of your products

·         80% of your sales are made by 20% of your sales staff

Therefore, many businesses have an easy access to dramatic improvements in profitability by focusing on the most effective areas and eliminating, ignoring, automating, delegating or re-training the rest, as appropriate.

Pareto analysis is a statistical technique in decision making that is used for selection of a limited number of tasks that produce significant overall effect. It uses the Pareto principle – the idea that by doing 20% of work, 80% of the advantage of doing the entire job can be generated. Or in terms of quality improvement, a large majority of problems (80%) are produced by a few key causes (20%).

Pareto analysis is a formal technique useful where many possible courses of action are competing for attention. In essence, the problem-solver estimates the benefit delivered by each action, then selects a number of the most effective actions that deliver a total benefit reasonably close to the maximal possible one.

Pareto analysis is a creative way of looking at causes of problems because it helps stimulate thinking and organize thoughts. However, it can be limited by its exclusion of possibly important problems which may be small initially, but which grow with time. It should be combined with other analytical tools such as failure mode and effects analysis and fault tree analysis for example.

This technique helps to identify the top 20% of causes that need to be addressed to resolve the 80% of the problems. Once the top 20% of the causes are identified, then tools like the Ishikawa diagram or Fish-bone Analysis can be used to identify the root causes of the problems.

The application of the Pareto analysis in risk management allows management to focus on the 20% of the risks that have the most impact on the project.

Steps to identify the important causes using Pareto analysis

·         Step 1: Form an explicit table listing the causes and their frequency as a percentage.

·         Step 2: Arrange the rows in the decreasing order of importance of the causes (i.e., the most important cause first)

·         Step 3: Add a cumulative percentage column to the table

·         Step 4: Plot with causes on x- and cumulative percentage on y-axis

·         Step 5: Join the above points to form a curve

·         Step 6: Plot (on the same graph) a bar graph with causes on x- and percent frequency on y-axis

·         Step 7: Draw line at 80% on y-axis parallel to x-axis. Then drop the line at the point of intersection with the curve on x-axis. This point on the x-axis separates the important causes (on the left) and trivial causes (on the right)

·         Step 8: Explicitly Review the chart to ensure that at least 80% of the causes are captured

Based on the above classification, causes are classified into three categories -

"A"  Class - they are few, therefore, must be controlled tighly. Frequent monitoring is required.

"B" Class - Important causes, significant portion. They can be control by the system.

"C" Class - Many causes but very less efffect. don't take risks, be lazy. Automatic system will take care.

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