The Pareto Principle And Decision Making

The Pareto Principle And Decision Making

The Pareto principle (also known as the 80/20 rule) states that, for many events, roughly 80% of the effects come from 20% of the causes. Management consultant Joseph M. Juran suggested the principle, and named it after Italian economist Vilfredo Pareto, who noted the 80/20 connection while at University in 1896, and published it in his first paper.

Essentially, Pareto showed that approximately 80% of the land in Italy at that time, was owned by 20% of the population. He developed the principle by observing that 20% of the peapods in his garden contained 80% of the peas.

Mathematically, the 80/20 rule is roughly diagrammed by a Pareto distribution, (see below) and many natural phenomena have been shown empirically to exhibit such a distribution.

Nature

  • The sizes of human settlements (few cities, many hamlets/villages)
  • The values of oil reserves in oil fields (a few large fields, many small fields)
  • Sizes of sand particles
  • Sizes of meteorites
  • Numbers of species per genus
  • Areas burnt in forest fires
  • Severity of large losses for insurance businesses such as general liability, commercial, auto, and workers compensation.
  • In hydrology the Pareto distribution is applied to extreme events such as annually maximum one-day rainfalls and river discharges.

Rule of Thumb

While it is common to referred to as the "80/20" rule, under the assumption that, in all situations, 20% of causes determine 80% of problems, this ratio is merely a convenient rule of thumb and is not, nor should it be, considered an immutable law of nature.

More generally, the Pareto Principle is the observation (not law) that most things in life are not distributed evenly. It can mean all of the following things:

Not distributed evenly

20% of the input creates 80% of the result
20% of the workers produce 80% of the result
20% of the customers create 80% of the revenue and often 80% problems as well
20% of software bugs cause 80% of the crashes
20% of software features cause 80% of the usage

And on and on…

Steps to identify important issues using 80/20 rule

  • Generate a table listing the issues and their frequency of occurrence as a percentage
  • Arrange the rows in decreasing order of importance of the issues (i.e. the most important one first)
  • Add a cumulative percentage column to the table, then plot the information
  • Plot (#1) a bar graph with items on x- and percent frequency on y-axis
  • Plot (#2) a curve with items on x- and cumulative percentage on y-axis
  • Next draw a horizontal dotted line at 80% from the y-axis to intersect the curve.
  • Then draw a vertical dotted line from the point of intersection to the x-axis. The vertical dotted line separates the important issues (on the left) and trivial ones (on the right)

Pareto distributions are often used in the cases when many different small independent factors contribute to a result.

Pareto Chart Example (Customer Complaints)

First find out how many customer complaints were received in each of, say, five categories.

Then take the largest category, let’s say in this case it is “documents”; break it down into, perhaps, six categories of document-related complaints, and show cumulative values.

If all complaints cause equal distress to the customer, working on eliminating document-related complaints would have the most impact, and of those, working on quality certificates should be most fruitful.

Pareto Example
Pareto Example - Document Issues

Draw a horizontal dotted line at 80% from the y-axis to intersect the curve.

Then draw a vertical dotted line from the point of intersection to the x-axis. The vertical dotted line separates the important causes (on the left) and trivial causes (on the right)

That means, in this example, quality certificate error, quality certificate missing and invoice error, (in that order) are what need to be worked on – the rest can be safely ignored.

Simple and effective.

Yaro Starak says

It really doesn’t matter what numbers you apply, the important thing to understand is that in your life there are certain activities you do (your 20 percent) that account for the majority (your 80 percent) of your happiness and outputs.

Life Isn’t Fair

What does it mean when we said above that “things aren’t distributed evenly”? The key point is that each unit of work (or time) doesn’t contribute the same amount.

In a perfect world, every employee would contribute the same amount, (red line in the graph below) every issue would be equally important, every feature would be equally loved by users. Planning would be so easy.

Pareto Distribution
Pareto Distribution

But that isn’t always the case:

The 80/20 rule observes that most things have an unequal distribution. Out of 5 things, perhaps 1 will be “cool”. That cool thing/idea/person will result in the majority of the impact of the group (the green line). We’d like life to be like the red line, where every piece contributes equally, but that doesn’t always happen.

Of course, this ratio can change. It could be 80/20, 90/10, or 90/20 (the numbers don’t have to add to 100!).

The key point is that most things are not 1/1, where each unit of “input” (effort, time, labour) contributes exactly the same amount of output.

Benefit:

The idea is to realise that you can focus your effort on the 20% that makes a difference, instead of the 80% that doesn’t add much.

In economics terms, there is diminishing marginal benefit. This is related to the law of diminishing returns: it means each additional hour of effort, each extra worker, is adding less “oomph” to the final result. By the end, you are spending lots of time on the minor details. Huge benefit right there.

Decision Making and The Pareto Principle

Think about 'diminishing marginal benefit'. Obviously building a bridge requires 100% of the construction to be completed, or else we don’t have a safe, working river crossing, but decisions, about almost anything in life, can be made using the 80/20 rule.

How so?

Look at the second graph, above, and come at it from the opposite direction, ie the right hand side moving left, you notice that at the 80 percentile of effort (bottom X axis) you will have achieved approx 96% of the result. (Take a line up to the green curve). A result in decision-making terms might be the level of certainty that the decision is correct.

Consider that effort is ‘researching if a decision is right or wrong’, then after we have 80% of the info - we are good to go. The last 20% of effort will only give you 4% more certainty. Why waste that effort?

A perfect reason for procrastinating just bit the dust. We DON’T NEED TO KNOW EVERYTHING before making a decision. So stop messing about, make that decision and get on with it.

The Pareto graph suggests, in fact, that at 50% of the effort/research/info you are likely to have a 90% result/certainty. Hmmm.

Stop. That’s Dangerous.

Yes, I can hear you. How do you know if you have reached 80%? Well you don’t. Not really. Just as you don’t know if you reach 100% of the required info.

Truth is – you never will. It’s all relative. A moving feast. We wrack our brains, ask experts, ask customers, do tests and experiments, contemplate our navel, but once the info gathering process appears to be slowing down, that is probably the 80% mark.

It’s a guess. You can keep guessing, or get on with doing stuff.

Decision Making Made Simple

  1. Get as much info as is reasonably easily obtained (remember, you don’t need to know everything – 80% is more than enough)
  2. Then ask yourself 2 questions about your impending decision.
    1. Knowing all that, what’s the worst that could happen? The very worst case scenario?
    2. Can I live with that? Yes/No.
  3. If yes. Just do it. Use the 5 second rule. But that’s another topic altogether.
  4. But, if no. You need to go right back to the beginning. Perhaps even think about if this is something you need to do, or decide. Or whatever.

Consequently, it really is that simple. Decision making on steroids. The 80/20 rule rocks.

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