Pareto Principle

It highlights that there exists an unequal or unbalanced relationship between inputs and outputs in a situation

David Bickerton

Reviewed by

David Bickerton

Expertise: Asset Management | Financial Analysis


September 30, 2023

What is Pareto Principle?

The Pareto principle was developed by the Italian economist Vilfredo Pareto and brought into the modern context by Joseph. M. Juran. Also often known as the 80/20 rule or the Pareto rule, the principle states that for many outcomes, roughly 80% of the consequences or effects (outputs) come from 20% of all causes (inputs). 

This concept's main aim is to highlight an unequal or unbalanced relationship between inputs and outputs in a situation. It explains how the majority of the output is because of only 20% of factors, which can thus be identified and prioritized. 

This principle is also often known as the law of vital few or the principle of factor sparsity. 

It is, however, to be noted that the Pareto rule is merely an observation and not a law. Although it can be applied broadly in many situations, there may be many scenarios where the Pareto principle doesn't work or may not give the exact percentages of 80 and 20. 

Understanding the Pareto Principle

The principle was originally developed by the Italian economist Vilfredo Pareto. In 1906, he came up with the observation that roughly 80% of the property in Italy was owned by about 20% of the population.

He then carried out surveys to find out similar distributions across most countries. A chart called the champagne-glass effect was compiled later by the United Nations in 1992, which showed that the wealthiest 20% in the world received 82.7% of the world's income.

This effect was brought into the modern world by Joseph M Juran, who used this principle in terms of quality control. He stated that 80% of the output in a firm was from 20% of the factors. 

He stated that 20% of resources should be focused upon and prioritized due to their importance. He explained this by using the term "vital few and useful to many," explaining that such resources were low in number but contributed the most and were the most productive.

This can be used in various fields like manufacturing, management, and human resources. The main use of this principle is to find the factor which contributes most to a particular event and focus one's efforts on that factor.

Example of the Pareto Principle

Let's take the example of a restaurant. The managers notice that they have put a lot of focus on the menu, the quality of food, the ambiance, and much more; however, they are facing fewer customers than their competitors.

The managers can thus use the 80/20 rule and find the critical differentiating factor between them and their competitors, which has the most significant impact on market share

After doing a proper analysis, the manager finds out that the main factor driving up revenue in the case of others is marketing. The other factors, while important, don't have as big an impact as marketing. 

Thus, the 80/20 rule helps management determine the most critical factor to help achieve a higher market share in the marketing initiatives. This means that management can focus its efforts on marketing and divert most of its budget towards it. 

This, however, doesn't mean that the other factors are completely irrelevant, as they still help in customer retention and word of mouth. Instead, it simply means that the majority of the focus should be on marketing initiatives.

Pareto Principle Uses

The 80/20 rule helps determine where one should focus their efforts to maximize output and productivity. If a particular result is segmented into smaller factors, the 80/20 rule can help a person identify the most influential part of that work.

1. Increasing Productivity

The 80/20 rule helps identify which tasks will have the maximum impact on the overall output. 

Thus, one can create improved outcomes by focusing efforts on only 20% of the most important tasks. This concept helps identify the most important activities and can help eliminate activities that have minimal effects on the outcome.

In the example above, management identified that marketing could help in having an influential impact on consumers. Thus, they maximized efficiency by using the majority of their time and efforts on the activity, giving them the biggest impact.

2. Better Decision-Making

The Pareto principle can help in making the best decisions in the problem-solving process. 

When a problem has multiple causes, this concept helps to identify which causes hold the most weight in the problem. By doing this, acts can be taken focusing on rectifying those causes.

For example, in the restaurant example, there could potentially have been a variety of causes for the problem of low customers, be it poor service, bad location, difficulty in finding parking, etc. 

However, these causes are comparatively minuscule compared to the major marketing problem.

3. Quality control

Based on the 80/20 rule, the Pareto chart is one of the significant tools used in quality control. It is a bar graph showing how much each cause or input contributes to an outcome or output. 

The length of each bar represents the cost of each cause which may be in terms of time, money, etc. The bars are arranged from longest to shortest to visually emphasize the most critical reason.

This chart helps emphasize which problem has the most significant impact and, thus, which problem should be focused upon the most. However, Pareto charts can also be used in several other ways, as described below:

  • First, to analyze the frequency of problems or defects in a particular situation.
  • In case multiple causes contribute to a problem, the chart can help focus most efforts on the most significant problem.
  • Communicating the significance of the problems to others. 

Pareto Principle Practical Applications

The 80-20 rule mainly identifies which factor holds the most weight in a particular outcome. This may have a positive or negative connotation. 

For example, it could refer to which hazards cause the most injuries in the workplace or which workers contribute most to the firm's overall output.

The principle helps one to focus on a few factors which are the most important instead of spending time and money on factors that may be of very little importance.

The 80/20 rule can be applied to various fields, from business to sports. Some examples of these applications are as follows:

  • In coding, Microsoft observed by fixing the top 20% of most common bugs, over 80% of errors and crashes can be prevented.
  • In health and safety, it is seen that 20% of the most common hazards account for over 80% of injuries. Thus by identifying these 20% of hazards and having safety precautions against them, most injuries can be avoided.
  • In a business, if it is seen that 80% of revenue is from 20% of customers. Then, the business can identify its target customers and build its strategies according to those customers.
  • At a personal level, the Pareto rule can also assist in time management for an individual. For example, instead of spreading out one’s time in multiple areas, using this principle, one can figure out which activity is most productive and focus on it. 

Pareto Principle Misconceptions

The Pareto principle should not be confused as a hard and fast law that must always be followed. It is simply a rule of thumb. While applicable in a lot of scenarios, there may be a lot of situations where this particular law may not be applicable. 

There may be situations where all the resources or factors are equally important. For example, there may be an organization where all the workers are equally efficient, thus making this concept inapplicable. 

Additionally, there may be situations where there are inequalities between inputs and outputs, but not in the exact ratio of 80% to 20%.

For example, if one has a list of 100 tasks, exactly 20% of them will have to hold the most value. On the other hand, it may be possible that 30 or even 40 tasks will lead to maximum impact.

The main message of the concept is that a small number of tasks may create the most impact on the overall output. The exact percentage may not always be 20%.

Lastly, focusing on the most important 20% of tasks does not always mean that the remaining 80% of tasks can be completely ignored. 

For example, in a business, the majority of costs may be labor and raw materials, while the rest of the costs, like electricity, water, packaging, postage, etc., hold very little weight.

The 80/20 rule doesn't say that miscellaneous expenses should be ignored entirely. 

Instead, it says that as labor and raw materials have the most significant impact, a business should spend most of the time trying to get those costs down and focus on the other expenses, but not ignore them. 

Key Takeaways

  • Also called the 80/20 rule, the Pareto principle states that 80% of outcomes or consequences come from 20% of inputs.
  • This helps to establish that there exists an imbalance between the inputs and outputs in any situation and specifies how a small percentage of inputs usually holds a lot more weight on the outcome.
  • The 80/20 rule is not a hard and fast rule that is always true. There may be situations where it isn’t applicable. It is simply a rule of thumb to identify the most valuable resources.
  • This concept helps in improving productivity and can save time and money. This is because it helps to identify the most important factors in any situation so that one can focus their time and efforts mainly on that factor.
  • The rule doesn’t state that the other 80% of the factors should be ignored entirely. It simply states that they are not as vital to the outcome; hence, more focus should be given to the more impactful 20%.

Pareto Principle FAQs

Elite Modeling Package

Everything You Need To Master Financial Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Soumil De | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: