Pareto Principle

What Is the Pareto Principle?

The Pareto Principle, named after esteemed economist Vilfredo Pareto, specifies that 80% of consequences come from 20% of the causes, asserting an unequal relationship between inputs and outputs. This principle serves as a general reminder that the relationship between inputs and outputs is not balanced. The Pareto Principle is also known as the Pareto Rule or the 80/20 Rule.

Understanding the Pareto Principle

The original observation of the Pareto Principle was linked to the relationship between wealth and population. According to what Pareto observed, 80% of the land in Italy was owned by 20% of the population. After surveying a number of other countries, he found the same applied abroad. For the most part, the Pareto Principle is an observation that things in life are not always distributed evenly.

The Pareto Principle can be applied in a wide range of areas such as manufacturing, management, and human resources. For instance, the efforts of 20% of a corporation's staff could drive 80% of the firm's profits. The Pareto Principle can be applied especially those businesses that are client-service based. It has been adopted by a variety of coaching and customer relationship management (CRM) software programs.

It can also be applied on a personal level. Time management is the most common use for the Pareto Principle, as most people tend to thinly spread out their time instead of focusing on the most important tasks. In terms of personal time management, 80% of your work-related output could come from only 20% of your time at work.

Example of the Pareto Principle

Financial advisory businesses commonly use the Pareto Principle to help manage their clients. The business is dependent on the advisor’s ability to provide excellent customer service, as its fees rely on its customers’ satisfaction. However, not every client provides the same amount of income to the advisor. If an advisory practice has 100 clients, according to the Pareto Principle, 80 percent of the financial advisor’s revenue should come from the top 20 clients. These 20 clients have the highest amount of assets and the highest fees charged.

Important

Advisory practices that have adopted the Pareto Principle have seen improvement in time management, productivity, and overall client satisfaction.

The Pareto Principle seems simple but is hard to implement for the typical financial advisor. The principle suggests that since 20 clients are paying 80 percent of the total fees, they should receive at least 80% of the customer service. Advisors should, therefore, spend most of their time cultivating the relationships of their top 20 clients.

However, as human nature suggests, this does not happen. Most advisors tend to spread out their time and services with less regard to a client’s status. If a client calls and has an issue, the advisor deals accordingly, regardless of how much income the client actually brings in to the advisor.

The principle has also led to advisors focusing on replicating their top 20% of clients, knowing that adding a client of that size immediately affects the bottom line.

Advantages of the Pareto Principle

There is a practical reason for applying the Pareto Principle. Simply, it can give you a window into who to reward or what to fix. For example, if 20% of the design flaws in a car are leading to 80% of the crashes, you can identify and fix those flaws. Similarly, if 20% of your customers are driving 80% of your sales, you may want to focus on those customers and reward them for their loyalty. In this sense, the Pareto Principle becomes a guide for how to allocate resources efficiently.

Disadvantages of the Pareto Principle

While the 80/20 split is true for Pareto's observation, that doesn't necessarily mean that it is always true. For instance, 30% of the workforce (or 30 out of 100 workers) may only complete 60% of the output. The remaining workers may not be as productive or may just be slacking off on the job. This further reiterates that the Pareto Principle is merely an observation and not necessarily a law.