The Pareto principle is also known as the 80:20 rule. This states that 80 percent of the outcome of a situation is caused by 20 percent of the inputs or contributors to the situation.
When dealing with challenges, the Pareto principle helps to identify the key areas to focus.
Application of the Pareto principle in business can provide insights that contribute to better management of the business. Examples include:
- Identification of the best-selling products or services.
- Identification of the biggest customers.
- Identification of high-cost areas.
The point here is to identify the key areas to delve into for further analysis or investigations.
In this article, we will explore how we can use the Pareto principle to reduce cost in our businesses.
The first step in this journey of cost reduction is to review your financial statement for the previous year and identify the high-cost bearing areas impacting the profitability of the business.
Equipped with the list of the areas or components of the business with high-cost figures, next action is to conduct further analysis of each of these areas using the Pareto principle.
The Pareto analysis on each of these areas will distil out 20 percent of the major contributors to their cost. You may be tempted to stop the analysis at the first level Pareto analysis; it is recommended that you carry out a second round of Pareto analysis on the 20 percent sub elements identified earlier. This ensures that the root causes or sources of the issues are identified.
For instance, if spend on material is of the high-cost areas from your review of the previous year’s financial statement, a sub level Pareto analysis on material will reveal the 20 percent of items contributing 80 percent of your material cost. These 20 percent of items that are responsible for the 80 percent material cost are the ones you should channel your cost reduction efforts to for maximum result. For example, you can renegotiate the prices of the materials, or seek for cheaper alternatives etc.
Stock or inventory is another area that can benefit from the Pareto analysis. The analysis will reveal the 20 percent of the products that are tying up 80 percent of your investment fund.
Once you have identified the high-cost inventories, you can explore cost reduction options such as reduction in the quantity of the high-cost inventory.
The 80:20 rule can be used to identify loss making and high maintenance customers.
Sometimes, high maintenance/difficult customers expect more from everyone else at lower price.
After identification of these high maintenance customers, compare the cost of keeping them against the revenues from them. In some cases, you will discover that you are making losses from some of these difficult customers.
To address the issue of customers with high maintenance cost, you can raise the price of the products or services offered to them. If they decide to stay despite the price increase, this is good for your business; and if they choose to leave due to the increased price, this is equally good for your business as you can channel the cost, energy, and time to a profit-making customer.