In 1904 Vilfredo Pareto, a noted Italian economist, studied the concentration of wealth in Italy and other European countries and found that 80 percent of wealth was held by 20 percent of the population. That same distribution was later applied to operations management by management author Joseph Juran in the 1940s. This has now become known as the “Pareto Principle” or the “80/20 Rule”. In many instances the populations of many a company’s business transactions takes on the same 80/20 distribution; i.e., 20 percent make up 80 percent of the dollars. Applying the 80/20 Rule focuses management’s efforts on better controlling high-dollar transactions that have the greatest business risk while allowing for a streamlined process for the rest. I’ve been recommending and implementing the 80/20 Rule on process improvement projects for my clients for quite some time. This has resulted in strengthened controls while reducing management time and costs. This is especially important in the current environment where companies are facing increasing risk management and regulatory compliance costs.
To demonstrate this concept, consider management controls surrounding, say, Purchasing transactions. A fairly simple analysis of the population of Purchasing transactions will bear out what Pareto taught us years ago; i.e., that 20 percent of the population of Purchasing transactions (POs) will represent 80 percent of the dollars spent by a company. Hence you can enhance management controls where you spend your money while reducing management time and costs where you do not.
I once observed a CFO who signed all of his company’s POs regardless of their amount. That CFO had turned himself into a glorified admin who was, in effect, rubber stamping all POs in front of him each day because he simply could not review the volume of POs on his desk. It would have been far better if he reviewed only the top 20 percent of the POs using an 80/20 analysis. Then, he could have actually spent the time to understand those high-dollar POs. All he was really doing was bottle-necking and driving up the transaction processing costs of the entire Purchasing operation while rendering himself useless as a CFO.
Here’s how to apply the Pareto Principle. Continuing with Purchasing transactions, list out all POs written over a sample period of time by downloading a listing of PO amounts to Excel. If taking a sample of only several months, you may want to adjust out or compensate for seasonality or business cycle differences. You should also exclude those types of purchases that are not necessarily pertinent to this type of analysis; e.g., electric utility bills. Then, add cumulative totaling and cumulative percentages to each row. It will soon become apparent where the 80/20 break point is located.
Companies often set ridiculously low approval authority thresholds for senior executives and are often surprised at how high the thresholds would if they used an 80/20 analysis. Often there needs to be an adjustment in the dollar threshold downward to allow for management’s comfort level. Nevertheless, it is far better to better control those transactions where money is being spent than to waste senior management’s time controlling transactions where it is not.
The Pareto Principle or the 80/20 rule can be applied to a wide variety of other types of transactions as well; e.g., check signing or cash disbursements and many other transaction control points. It can be used to better control risk management and compliance costs. In addition, it can be applied to focus customer service and business development to the 20 percent of the customers that represent 80 percent of the revenue. Hence, better management controls at reduced costs. All thanks to Vilfredo Pareto!
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