Management Accounting-Decision Management: Grahame Steven Explains How the Identification of Vilfredo Pareto's "Predictable Imbalance" Can Help a Business to Improve Its Performance
Steven, Grahame, Financial Management (UK)
The Italian economist Vilfredo Pareto derived what has become known as Pareto's law from his studies of income distribution in a number of countries at the turn of the 20th century. He found that roughly 80 per cent of the wealth was held by 20 per cent of the people and that the number of people holding a particular level of wealth fell by a constant factor each time that level was doubled. While his findings were taken as proof by some people of the inequities of capitalism, Pareto predicted that his law of "predictable imbalance" would also apply to communist societies. Studies conducted in the Soviet Union during the Seventies confirmed the accuracy of his forecast.
The law, which identifies the "vital few and the trivial many", has been observed in a wide range of situations. For example, 80 per cent of a tutor's time is taken up by 20 per cent of the students; 80 per cent of interruptions come from 20 per cent of the class; and 80 per cent of decisions in meetings come from 20 per cent of the time.
One of the first uses of Pareto analysis in business was for the purposes of quality management. Joseph Juran, a pioneer of modern quality methods, observed that most quality problems arose from only a few causes. Pareto analysis enabled managers to focus on the problems whose resolution would bring the greatest benefit to the enterprise. For example, IBM found, after analysing computer processing time, that 80 per cent of processing time was concerned with executing 20 per cent of software operating code. As a result, its programmers rewrote the code to make the most frequently used parts of it as streamlined as possible.
Pareto analysis is also a valuable management accounting tool, because it can be applied to a company's customers, products, departments, branches, suppliers, employees and so on to obtain insights with a view to improving efficiency and effectiveness. Consider figure 1, which shows the sales income gained by a company called Customer Focus Ltd (CFL) from each of its 20 customers over the past year. The first step in a Pareto analysis is to sort the customers in descending order according to their sales values; the next step is to calculate cumulative sales; and the final step is to calculate cumulative sales percentages, as in figure 2. While this shows that 73.9 per cent of CFL's sales come from 20 per cent of its customers, its figures can be used to create a Pareto chart to give a more visual representation of the importance of the "vital few". The data can be entered into Microsoft Excel's graphing function to produce plots showing cumulative sales by value or percentage (see figure 3).
Like any management accounting technique, Pareto analysis must be used with care, since it provides only an insight into a particular business issue. Further consideration and analysis is required to determine what action should be taken. Although it is tempting to conclude from this analysis that CFL should stop supplying goods to most of its customers, such a course of action may prove short-sighted. More information is required to determine whether or not a withdrawal strategy is appropriate for these customers. What is the total business available at that company? Is the business expanding? Is CFL part of a larger group?
It wouldn't make sense for the company to stop doing business with large customers to which it currently makes few sales, small customers that are expected to expand their businesses or customers that are part of a larger group. The object of the exercise is to identify customers with poor current and future sales potential. Decisions, made after further analysis, would then be taken based on which customers CFL is prepared to do business with in the future.
Multiple analyses of the same data--sales, contribution and profit--may also be undertaken to provide a more in-depth view of the issue under consideration. …