Pareto’s Law can show up in many areas of your business, as well as the world around us.

• Of the total number of drivers that qualified in NHRA Pro Stock in the 2002 season, 20% of them qualified in about 80% of all the races.

• Many times, 80% of employee problems come from 20% of the employees. Are these employees being properly and consistently managed to reduce your headaches?

• Illinois Tool Works, Inc. (NYSE: ITW) successfully uses 80/20 as one of their core philosophies. This $9.3 billion company has acquired hundreds of companies over the years, and applies the 80/20 principle to trim under-performing product lines and increase profits. ITW's philosophy is that each of their more than 600 decentralized business units are structured to focus on the 20% of products and customers that produce 80% of the sales dollars.

• Pareto's Law of income distribution no longer applies to the modern-day United States, but does apply to total family wealth : today in the U.S., 20% of U.S. families do have 80% of the wealth. However, it's close worldwide: 16% of the world's total population receives 84% of the income, according to a recent World Bank study.

Use an 80/20 Analysis to Increase Your Profits.

Reprinted from SEMA News magazine, May 2003

A simple, century-old principle that can increase your profits is right under your nose, and is easy to use. You've undoubtedly heard about the "80/20" principle, although few people really understand how it can be used. Or at least, they only understand 80% of it, 20% of the time.

Let's look at how this 80/20 principle can be used to streamline your business, reduce your costs, and increase your profits.

First, a quick history lesson: Vilfredo Pareto was an Italian economist and sociologist born in 1848. "Pareto's Law" claimed in 1897 that basically, in any society, 20% of the people would earn 80% of the income.

Pareto's discoveries, now usually referred to at the Pareto Principle or the "80/20" principle, have been pilfered to be used with many other things that Pareto could never have imagined (see sidebar). Many people are surprised at how often Pareto's Law appears, and how easy it is to use the 80/20 principle your business.

Pareto in your business

Pareto's Law is old news to a lot of Industrial Engineers and people in the Quality profession dealing with process improvement, but it can be used to analyze a variety of other things in your business. If you're a manufacturer you can use Pareto's Law to evaluate whether to add to or eliminate part of your product line, or evaluate your customers. If you're a WD, you can use it to analyze your stocking inventory (and to determine how many of those SKUs that manufacturers claim are "AA movers" really are). Jobbers can use it as a tool to allocate floor and shelf space.

The point of all this is that you focus your efforts on the few products or customers that bring in most of your revenue.

If you're a manufacturer's rep, you can use it to see where the bulk of your commissions are coming from to allocate your time and resources (note to reps: tell your factories that this whole Pareto thing is a dumb idea and you refuse to have anything to do with it).

Step One

Let's imagine you own Pareto Pistons, a manufacturer with $10 million in sales. Gather the gross sales history for all of your part numbers for the past 12 months in a spreadsheet like Microsoft Excel. Include everything that you sell, including cataloged part numbers and component parts if you sell those. If you can also list the total gross profit generated by each part number, that's even better and you're ahead of most of your competitors. Sort your list in descending order, with your biggest seller at the top of the list. Manufacturers: if you use MRP or ERP software in your business, it may be able to produce an ABC analysis with this type of information.

Your list should look something like this:
A
B
C
1
Part Number Total Sales $ Gross Profit $
2
10-10345  $1,542,034 $539,711
3
10-43445 $845,453 $321,272
4
30-30325 $798,568 $239,570
5
10-10355 $643,506 $254,532
6
40-55055 $235,245 $105,860
7
50-10000 $186,456 $85,459
8
etc. etc. etc.

Since your list will include all your part numbers, it will be hundreds, or thousands, of part numbers long (by the way, if it's thousands and you're a $10 million manufacturer, you really need this analysis!).

If you total the sales column it should equal your gross sales for the year, and the gross profit column should equal your gross profit for the year.

Step Two

If you have never looked at your product sales this way, this step may be an "a-ha! moment" for you. You will quickly visualize where most of your sales come from, which you might have intuitively suspected anyway.

Look at what else the data shows you. In the example above, we only listed five part numbers so far, but already the top three "10-" series parts make up about 30% of your total sales. Ask yourself if there is anything you can do to expand on the success of the 10- series: maybe you should develop more applications, or allocate more marketing dollars.

Now that you can see what your customers are buying, sort your data by gross profit and see what is actually helping pay your electric bill. In this example, 30-30325 generates more sales dollars than 10-10355, but 10-10355 generates more gross profit. Does your management team understand why one is more profitable than the other?

Step Three

This is the "meat and potatoes" part of your analysis. Total the sales of your part numbers until you reach about $8 million, or 80% of total sales at Pareto Pistons. If you regularly review product lines and discontinue older products on a regular basis, you will probably find that 15% to 25% of your total part numbers generate this 80% of your sales dollars. If you have not reviewed your product line for a long time (or ever?), don't be surprised if only 10% of your part numbers generate 80% of your sales.

Now is the time for tough decisions. Look at the bottom of your list. What is the cost to sell those parts that represent such a small part of your total sales or gross profit? How much overhead, labor and materials are used by the 80% of the parts that represent 20% of your sales (hint: it is much more than 20% of your costs). How much more profit would you have if you eliminated low-volume, high-cost parts?

A word of warning: At this point, the Pareto Pistons sales staff will be screaming that you can't possibly eliminate these products. Sales people want to sell! On the other hand, your plant manager and accountant will be intrigued by this idea and will wonder if you can eliminate even more of your product line to concentrate on the high volume products. You will have to listen to both sides and make the best decisions.

This analysis is simply a tool, like a wrench. Anyone can use a wrench but you have to decide how hard to tighten the bolts.

Conclusion

The 80/20 rule shows up in some amazing places. I first observed two decades ago running a small print shop, when we discovered 80% of our sales were coming from 20% of our customer base (of course, we used yellow notepad paper and an old-fashioned calculator), so we focused on what we could do to increase sales from those customers.

With some imagination you can make Vilfredo Pareto an unpaid consultant to your business, and increase your bottom line. It may not help in all cases, but hopefully it will work for you at least 80% of the time.

Copyright 2003 Jon Hedges, all rights reserved. Limited reproduction crediting the author is permitted. Jon Hedges is not affiliated with or performing any services for Illinois Tool Works, Inc.

About Us | Site Map | Terms of Use & Privacy Policy | Contact Us | ©2008 Hedges Management Inc., all rights reserved. Use of this site constitutes acceptance of Terms of Use. Web site design by Hedges & Company.