Case Topic: Chapter 3 Pareto's Law Article

Improving almost everything with Paretos Law

Whether you are responsible for a factory or a church, youll do better by applying this simple management precept

By Ray J. Bronikowski

Kiwanis Magazine/February 1980

In the Pocono Mountains of eastern Pennsylvania, a manufacturer of power line hardware was in trouble. Sales were growing, but profits were shrinking. The more hardware sold, the less profit made. Pete Cliffton, the manager, had to effect a profit boost.

Analyzing each of the several thousand items manufactured, from a two-ounce washer to a 200-pound bracket, Pete found what Paretos Law predicted: 20 percent of the items produced accounted for 80 percent of the sales and almost all the profit.

He made a tough decision, one that his sales department grumbled about. He turned down new orders on all items that were not part of the top 20 percent group. Pete told his salesmen that survival of the business depended on being profitable, and he asked them to encourage customers to switch to the preferred list of products in the top 20 percent. Customers would benefit from rapid delivery because large inventories would be maintained on those items.

It took about a year to effect a turnaround, but during the second year of the plan, that hardware plant became one of the profit leaders of the industry.

Pete understood and applied Paretos Law, which states, In almost every area of business, economic, or social activity, 80 percent of the key outputs are directly attributable to 20 percent of the key inputs. Thus, Paretos Law predicts that 80 percent of the sales come from 20 percent of the products manufactured. Furthermore, 80 percent of sales result from the efforts of 20 percent of the sales force.

The law is named after Vilfredo Pareto, an Italian economist and engineer. In 1897, after concluding that a very large percentage of the national income was concentrated in a small percentage of the population, he published his findings in mathematical form.

Paretos Law has applications beyond sales and profits. Joseph M Juran, a management consultant and quality control expert, called Paretos Law a universal for analysis because it focuses on the vital few and the trivial many that occur in many types of activities.

For example, a Midwest church congregation was having financial problems. Income was falling below the budget based on the parishioners pledges. The pastor and his finance committee began a review of the members donations. The committeemen developed a composite ranking of donations, with the highest contributor first, the lowest last.

There were 805 members in the congregation. Counting down 161 names (20 percent), the finance chairman totaled the contributions of this group as well as the grand total for the congregation. He took a separate total for a group at the bottom that had unusually low contributions. He discovered that the top 20 percent contributed 78 percent; the next 44 percent contributed 18 percent, and the remaining 36 percent contributed only 4 percent.

After its initial surprise, the finance committee realized that it had a very useful listing. The top 20 percent would receive letters of appreciation and a request for continued support of the congregation.

The next 44 percent received letters encouraging them to improve their contributions to the level pledged, making a tactful statement about other contribution levels, and thanking them for their support. This group had potential for increased contributions.

The remaining 36 percent needed careful review. Some of them may have been deadbeats, but certainly not all. Had some of them moved, or changed affiliations? How many of them were needy families, requiring spiritual and perhaps financial help from the congregation?

In this case, by analyzing the contributions, the committee obtained much more information about the congregation than just who gave, who didnt, and how much.

Listing data from the highest to the lowest makes it possible to quickly find Paretos Law relationships. The owner of a small manufacturing plant had inventory problems. It seemed that his assemblers would run out of some part-often nuts and bolts- in the middle of a production run. John, the owner, was understandably irritated because he maintained close control over his inventory. Frequent counts were made on each item, down to the last washer and rivet. He wanted no excess dollars tied up in inventory.

After several frustrating stock-outs, John asked a management consultant for help. After reviewing the situation, the consultant recommended an inventory management program based on Paretos Law-the vital few and the trivial many.

The top 20 percent of items in dollar value were to be monitored closely, purchased carefully, and counted frequently. They represented nearly 80 percent of the inventory dollars.

The remaining 80 percent of the items included nuts, bolts, washers, and rivets and were to be monitored by the stockroom clerk. The consultant set a reorder point on most items, and the clerk was instructed to watch for low inventory on fast-moving items. When the reorder point was reached, the clerk sent through a purchasing request. The buyer would immediately order a two to six month supply, based on quantity price breaks and delivery.

Two or three times a year, a spot inventory was taken on a dozen randomly selected items to see how closely the stock levels compared to the inventory cards.

John was happy to learn that this method cut the cost of keeping track of inventory in half. More importantly it almost eliminated the risk of running out of small parts during a production run.

Having larger quantities of inexpensive parts on hand cost very little more than ordering them on a rush basis, then running out if a delivery was delayed. Im learning more about running my business and less about being a nuts and bolts expediter, John concluded. And I sleep better, too.

Sales territories also follow Paretos Law relationships. Just as 20 percent of the salesmen account for 80 percent of the sales, most of the sales of an individual salesman are generated by just a few of his customers. Joseph M. Juran, the expert mentioned earlier, found a variation of Paretos Law that applies well to sales territories. He noted, In territory after territory, 15 percent of the customers account for 65 percent of the sales, the next 20 percent account for 20 percent, and the remaining 65 percent account for only 15 percent of sales.

If a salesman allocates his time to those customers who give him a lot of business, it produces a better return on the investment of his time than spending it on those who purchase little. The exception to this is a low-buying customer with a high potential who must be cultivated to develop that potential into sales.

To determine which customers fit each category, they must be ranked from highest dollar sales per year to lowest. In many cases, Jurans modification of Paretos Law will be evident. Natural breaks between categories of sales levels will occur near the predicted points.

However, a salesmans territory usually wont have all the good customers in one city. So he must balance his calls between his high, medium, and low dollar sales list. He needs to make sure that his best customers are called on most frequently, perhaps on each visit to their city. Overall, it is important that the top 15 percent of a salesmans accounts receive about 65 percent of his available calls. He should also allocate about 5 percent of his available calls on cold contacts seeking new business where none existed, and another 5 percent on extra calls to upgrade existing customers from a lower level to a higher one.

This concept works not only in a broad sales territory but in one that is fixed, such as a shoe store or mens or womens specialty store. Even though many sales are by cash, credit cards are often used. These make it easy to identify good, repeat customers and recognize them when they return. This 15 percent of the customers deserve 65 percent of the sales effort.

Paretos Law relationships will also help a store operator realize that most of his sales dollars will come from sales of only a small percentage of his stock on hand. Perhaps that unusual, brightly colored group of womens blouses will sell, or else the tailored blouses will have more appeal. It may be difficult to spot a trend immediately, but the sooner it can be done, the more likely the merchant is to have time to develop adequate stocks of the right merchandise to sell.

The previous examples and case histories are only a few of the countless situations in which Paretos Law applies. Consider your occupation or business and speculate:

• 20 percent of your personnel will cause 80 percent of your grievances, turnover, and mistakes, waste.
• 20 percent of your inventory is used in 80 percent of your production and encounters 80 percent of the shipping delays.
• 20 percent of your components account for 80 percent of your projects.
• When applying Paretos Law to each facet of your business, remember that it is important to list an item from highest value to lowest, because additional information can sometimes be found, as the following example illustrates.

The manager of an electrical equipment manufacturer began a review of his previous years sales and profits, which had been compiled in a highest dollar-volume printout. Using Paretos Law, he predicted that of the 1,736 catalog items in the printout, the top 347 (20 percent) would account for 80 percent of the $6 million total sales. His analysis showed that they accounted for $5 million, or 83 percent of sales. However, the top 20 percent provided only 68 percent of the profit dollars. Probing through the list, which included costs as well, he spotted the problems. Not only did the list show the big winners, it also showed those items selling at too low a price to be profitable- the big losers.

This additional information allowed him to look more deeply into product families in which similar parts are assembled into products with a range of electrical ratings. Certain of these family members sold at very high volumes but very low prices because of competition. The high volume and low profit indicated that they were popular items that were probably over designed, poorly engineered, or being manufactured inefficiently at too high a cost. Without knowing the precise cause, he knew that they were candidates for value analysis or cost reduction programs.

What is possible in a large business can also be done on a smaller scale by many store owners. Computer costs are coming down, and computer services are available almost everywhere. In many cases, the saving that can be realizes by applying Paretos Law to sales and profits will cover the cost of gathering the data and analyzing it in a small business.

However, before buying a computer or hiring a data processing service, a small business should try a Paretos Law analysis on its own, manually, much like the church congregation did. By listing sales for highest-selling item to lowest, the items that have sold the best (and the worst) will quickly become apparent and corrective actions can be taken without spending money for computer time.

Once Paretos Law has been applied in a business, it must be used continuously. Otherwise, bad habits return that will nullify the gains. I have already described the experience of Pete Cliffton in the hardware manufacturing plant. This is the sequel to the story.

After a few years, Pete left to take a better job with another company. A new manager, George Dawes, took over. Eager to do everything right, George became very concerned by the salesmen complaints that their lack of a full line of hardware was hurting their sales growth. He didnt listen to his old-timers or read through Petes files.

George thought that a little new business would lead to a whole lot more. So the plant began accepting orders for special items, a few here, a few there. Soon the trickle of requests for specials became a flood. The plant became swamped handling existing business and coping with all of the new orders. Sales grew, profits sank.

George lasted for a little over a year. It hadnt taken long for the profitable hardware plant to once again become a big loser. The third manager, Bill Bardick, was told to get the plant profitable again and keep it that way!

After reviewing the experiences of his two predecessors, Bill applied Paretos Law again, to find the big winners and cut out the big losers. And just as important, he taught this management method to his marketing, engineering, and production staffs. They still make an occasional special order at the plant in the Poconos, but only if they believe there is adequate growth potential. And the special either grows or gets phased out.

This is a true story, with only the names changed. This is where I first heard about Paretos Law and saw it applied.

Your business may be larger of smaller than the hardware plant. But regardless of its size, you have many things to do, many items to make or sell, many people to contact. Concentrate on the few actions or items that are vital to doing your job well. That is the substance of Paretos Law. Whether you are in a profit-making organization, a church group, or a service organization such as Kiwanis, you can use Paretos Law to maximize the results of your efforts. ~

Instructions:

How can you implement this concept in your own life? If you do this (home, work, school, hobbies, volunteering, etc), then how will you monitor this concept after you try it? Like the inventories, you may need to review it periodically- how will you do it?