Pareto Principle

The 80/20 Rule

What is the Pareto Principle?

The Pareto principle, also known as the 80/20 rule, was one of Vilfredo Pareto’s most noteworthy theories, which found that 80% of outcomes often come from 20% of the related inputs. Pareto was an Italian economist in the 19th and 20th centuries who helped develop modern economics as we know it today.

 

Pareto Principle

 

Pareto first saw the situation when evaluating income distribution in Italy, where he saw that 80% of the country’s income went to only 20% of the population. His theory stretches far beyond just income and can be found throughout many business and consumer fields.

As a whole, the theory suggests that many aspects of life are not distributed evenly. The Pareto principle is also referred to as the “vital few” and “useful many.”

 

Summary

  • The Pareto principle, commonly referred to as the 80/20 rule, suggests that 80% of results/outcomes will result from 20% of the actions/inputs that can be associated with it.
  • The rule can be viewed in two ways, either the vital few, which a small number (20%) of factors result in the vast majority (80%) of results or the useful many that find that many sources account for a small number of results.
  • The Pareto principle is an analytical tool to help organize thoughts and develop solutions to business and consumer problems.

 

Practical Applications

The Pareto principle can be seen across many sectors of business and within consumerism. Below are a few examples of where it might be found:

  • 80% of the work in a group project is done by 20% of the group
  • 80% of revenues come from 20% of the products
  • 80% of engine failures come from 20% of possible causes

 

Importance of the Pareto Principle

The Pareto principle is a helpful rule of thumb when trying to optimize the allocation of resources. The correct distribution of resources can make a significant difference in the efficiency and profitability of a business.

For example, think about if a new CEO is hired to boost client retention for a small business. If 80% of the reason their clients are leaving is caused by 20% of the possible problems, it would be a no-brainer to focus on the first 20%.

The 80/20 rule is a great decision-making tool to help optimize resource allocation for a business. It helps organize the thought process and make much more educated decisions.

The rule also plays into the law of diminishing marginal return/benefit. Keeping all else equal, when the consumption of inputs increases, the marginal benefit of each additional output will decrease.

 

Benefits and Limitations

The Pareto principle offers several benefits, mostly surrounding the analysis that it can be used for. It can help analyze problems within a company, organize the thoughts behind them, and provide the most effective solutions.

An important note to remember when thinking about the Pareto principle is that it is merely a rule of thumb and not a hard law that is always followed.

 

Other Related Pareto Theories

Pareto analysis is an analytical tool used to aid decision-making. It is a statistical approach to rank problems within a business and uses the data to make decisions. Pareto diagrams and tables can be used to help visualize the findings. The findings will often resemble the Pareto principle as either:

  • The Vital Few: A small number of inputs lead to a large majority of the outputs.
  • The Useful Many: A large number of inputs lead to a small part of the entire problem.

 

Other similar theories developed by Vilfredo Pareto include Pareto efficiency, Pareto inefficiency, and Pareto improvement. All of which relate to the Production-Possibilities Frontier. Any point on the frontier that is Pareto inefficient will enjoy the opportunity of a Pareto improvement to move towards Pareto efficiency.

 

More Resources

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)® certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Pareto Analysis
  • Allocational Efficiency
  • Pareto Improvement
  • Point of Diminishing Returns

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