Pareto Principle : 80-20 Rule

What Is the Pareto Principle?

The Pareto Principle, named after 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.

KEY TAKEAWAYS

• The Pareto Principle states that 80% of consequences come from 20% of the causes. "Pareto Analysis."
• The principle, which was derived from the imbalance of land ownership in Italy, is commonly used to illustrate the notion that not things are equal, and the minority owns the majority.
• Unlike other principles, the Pareto Principle is merely an observation, not law. Although broadly applied, it does not apply to every scenario.

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.

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.

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