Applying the 80/20 Rule for Expenses
What is the 80/20 Rule?
The 80/20 rule is also called the Pareto principle. Having been invented by an Italian engineer, socialist and an economist, in general terms, the rule asserts that 80% of the output or results is generated by 20% of the input or the effort. Vilfredo Pareto is said to have come up with the principle when he observed in his garden that only 20% of his pea plants generated 80% of the healthy pea pods. In seeking to apply the rule in other areas of life he observed that 80% of the land in Italy was owned by 20% of the wealthy families. Upon examination of other sectors of the economy, he realized that the principle applied there also. He observed that 80% of the produce came from 20% of the companies (Eatough, 2021).
How Does the Pareto Principle Work?
According to Kibet (2021), 80% of consequences originate from 20% of the causes. The Pareto principle can be applied in almost all sectors of life including personal finance, business, productivity, retirement and investment. The rule is based on the assumption that it is important to prioritize the vital few as opposed to the trivial many.
In terms of efficiency, the Pareto principle holds that 20% of the inputs generate 80% of the output. This principle has been widely applied in businesses to increase profitability, productivity and reduce expenses. This principle can be applied in almost all real-life practices such as weight loss, goals and eating habits. The observation of this rule in business shows that 20% of the goods and services take about 80% of the expenses, 80% of the revenues from 20% of the sales and the same amount of revenue applies to clients, products and personnel (Eatough, 2021).
What are some of the areas where the Pareto rule can be applied in business?
The Pareto Principle is a general rule that can be applied in many aspects of business, management and strategies. The rule can be applied or reoriented to focus on whichever business strategy a person wants especially on the crucial areas of the operations.
Household Expenses Review. Pareto analysis can be used to conduct cost efficiency on personal household expenditure as well as planning the cost-saving to reduce overruns on monthly budgets. Some of the items to consider in expenditure management include:
- Utilities such as water, electricity, telephone among others.
- Transportation expenses such as car maintenance, car parking and fuel among others.
- Grocery purchases
- sporting activities
- Entertainment
- Household supplies and repairs
- Children school books and fee
- Home security
- Cleaning services
In the case for the listed expenditures, Eyushadi (2015) found out that the first five items represented 20% of the cost expenses items hence will cater for 80% of the total cost expenditure (Eyushadi, 2015).
Sample Pareto Chart for Expenses
Source: Eyoushadi (2015)
The Pareto Chart above shows that the items that need more focus in a bid to achieve cost efficiency are groceries, transportation costs, kids-related expenditures, Utility bills and sporting activities. Given these five items, the focus should be based on the top 5 items identified above that are to be reviewed as they cover over 80% of the total costs (Eyushadi, 2015).
After identifying each of the above 5 items, specific strategies can be designed to minimize or eliminate the expenses or costs associated with each particular item of concern. On groceries, a person can decide to be buying only the necessary items and avoid spending on unnecessary items. On the transportation item, one can choose to use public transport to reduce transportation expenditures. Electricity and water efficiency can be achieved through energy and water conservation mechanisms. On the expenditure for kids, there is a minimal chance for saving due to the essential nature of the item.
Can the Pareto Principle be Applied to Labor expenditure?
The Pareto principle can be applied in business organizations to reduce labor costs and expenses. These expenses include salaries and wages as well as equipment and machinery. The Pareto rule, in this case, implies that 20% of a company’s labor contributes to 80% of the business success. The goal of the management, in this case, is to improve 80% of the workforce to become like the efficient 20%. This leads to optimal allocation of training resources to only those areas of labor that contribute to the profitability or productivity of the company. Some of the expenses to focus on include employee training expenditure, communication and hiring expenses by spending on the relevant fields only (Launch Team Inc, 2020).
Can the Pareto Principle help Manage Equipment and Machinery Expenses?
Equipment is important for ease of labor, speed and efficiency in carrying out organizational tasks. The application of the Pareto principle in this context entails the knowledge that 20% of the equipment and machinery contributes to 80% of the organizational results. It could also be interpreted that 20% of the machinery contributes to 80% of the production waste hence the strategy to minimize the expenses must take into consideration the direction of the Pareto rule (Launch Team Inc, 2021).
How is the Pareto Principle Applied in Managing Business Expenses?
This requires the identification of 20% of the inputs and 80% of the output or results. Expenses are a broad aspect of business and are incurred at different areas or departments of a business such as sales, production, personnel and customers hence the application of the Pareto efficiency should be focused on each specific department or area of concern. Looking at the customers, the rule can be used to identify which customers buy most of the goods and or services that a company offers. Looking at the personnel, the rule can be used to identify which workers contribute the most in terms of labor. The same can be applied in determining which goods and services generate the most profits for the business.
The next step after identifying the priority areas and functions is the identification of the costs that are expended in each particular area of concern. As reiterated by Etough (2021), one should focus most of their efforts on the top 20 per cent of the parameters that lead to 80% of the results by reducing expenditure on those areas that are less productive for the business. Most of the expenditures that are spent on less productive areas should be shifted to those areas 20% that generate 80% of the output. For example, knowing that 80% of the sales are made by 20% of the sales force, the management should focus most of its attention on the high-performing salespeople by assigning more salary expenditures and upgrading their welfare to enhance their productivity. Upon identifying the 20% of the customers, the business can focus most of their marketing attention and expenditure on trying to reach those high profile customers or clients for the business. Nevertheless, this shift does not mean ignoring or neglecting the other 80% of the areas that do not generate much for the business (Etough, 2021).
But does the Pareto Principle apply Always?
According to Etough (2021), the 80/20 rule is not a mathematical law but a general observation that does not hold in all cases. There are natural variations for the law whereby people might misinterpret the law and blindly focus all their efforts on the 20% and completely neglect the other portion. For example in some situations, it is found that 80% of the expenses go to functions that generate 20% of the revenues. Instead of neglecting these areas completely, the management should focus on improving them to become part of the 20%. While it is ideal to spend more on marketing to the 20% of the customers who generate the most, a business should focus on making the 80% part of the 20%. The 80/20 rule can be used to identify those areas that need much expenditure and those that generate little output whereby a business can reduce expenditure on less profitable areas. In terms of expenses or costs, the Pareto principle helps businesses do more with less.
How can the Pareto Principle be applied in Procurement to Reduce Costs?
Cost reduction is one of the most important functions of the procurement department within an organization. The reduction of expenses can be achieved by identifying where costs and spending exist within the procurement unit. The 80/20 rule can then be applied by developing procurement strategies that help reduce or eliminate costs and expenses for businesses. The procurement professionals should be able to analyze procurement expenditures and identify where the highest expenses are located within the organization. The benefits of the spend analysis include improved supplier management, lower inventories, reduced costs as well as allowing to refocus resources on the key strategic issues in procurement (Oxford College, 2014).
The 80/20 rule can be applied to the total expenditure that a company utilizes in the procurement processes. This principle helps in the identification of the items that a company should focus on in an attempt to reduce expenses. A clear observation of the 80/20 rule shows that 80% of a company’s expenditure is spent on 20% of the purchases made. The procurement professionals can therefore use this rule to analyze the items, materials and services purchased to classify those that can be approached to reduce prices and cut down on costs of purchases. The procurement professionals can use this analysis and information to reduce the purchases that are expended on the 20%. This process goes through a continuous cycle of evaluation until effectiveness and efficiency are achieved by ensuring cost-effectiveness and fair buying prices (Oxford College, 2014).
Can the 80/20 Rule be Applied in Managing Personal Expenses?
The 80/20 rule can be used in income budgeting whereby 20% of personal income is taken to a saving account and the 80 is spent on various purposes. The Pareto rule can be used as a simple version of the 50/30/20 rule whereby 50% of income is spent on needs, 30% on wants and 20% is saved. The application of the 80/20 rule is more effective after all the necessary deductions such as tax expenses, health care and other expenses are deducted out of the paycheck (Pant, 2021). The key to success and efficiency is focusing on 20% and avoiding wasting effort, time and financial resources on less beneficial causes.
Can the Pareto be Applied on Time Spend in Carrying out Business Activities?
Time is an important resource that businesses should beware of. Businesses ought to consider the time they spend on the results that they achieve in their activities. The Pareto Principle can effectively be applied in time management and business profitability. Time-efficient businesses know that it is inefficient to focus their entire effort on the business when they can reap the most benefits from a minority of their efforts. This calls for businesses to concentrate their time on 20% that yields 80% of the benefits or even to spend 80% of their time on 20% of the activities that generate 80% of the benefits (Stearn, 2021).
What are the Steps in Implementing the Pareto Principle?
The Pareto principle is an easy decision-making tool that is used to assess competing problems and evaluate the effect of solving them.
The implementation of the 80/20 rule begins with the steps for Pareto Analysis.
- Identification and listing of the problems. This involves writing down all the problems that an enterprise wants to solve.
- Identification of the root causes for each problem. This can be done by the use of cause and effect analysis, 5 whys, root cause analysis among others.
- Score problems. This involves assigning importance to each problem that has been listed based on their suitable criteria.
- Grouping the problems. This involves classifying the problems into clusters based on their causative factors.
- Adding up the scores for each cluster. This involves adding up the scores for each group that has been identified. The cluster with the highest score becomes the top priority whereas the least score attracts the least priority.
- Taking action. This involves coming up with ideas on how to make better the cluster with the topmost priority (Mind Tools, 2021).
The Pareto principle is a universal law that can be applied in almost every aspect of business management hence proper use of the tools can lead to great cost-saving and reduction of expenditures by businesses around the world.
References
Etough, E. (2021). The Pareto Principle: How the 80/20 Rule Can Help you do More with Less. Better. https://www.betterup.com/blog/pareto-principle
Oxford College (2014) How to Use Pareto Analysis in Procurement to Reduce Costs. College of Procurement and Supply. https://www.oxfordcollegeofprocurementandsupply.com/how- to-use-Pareto-analysis-in-procurement/
Pant, P. (2021) The 80/20 Rule of Thumb for Budgeting. The Balance. https://www.thebalance.com/dont-like-trcking-expenses-try-the-80-20-budget-453602
Kibet, L. (2021) What is the Pareto Principle or 80/20 Rule and How is Best Applied for Finance. Banking Rates.
https://www.gobankingrates/money/financial-planning/pareto-principle/
Stearn, R. (2021) Applying the Pareto Principle. Expense Reduction Analysis. https://www.uk.expensereduction.com/news/applying-pareto-principle/
Mind Tools (2021) Pareto Analysis. Emerald Works. https://www.mindtools.com/pages/article/newTED_01.htm
Launch Team Incorporated (2021) Applying the 80/20 Rule Strategy in Advanced Manufacturing. https://www.launchteaminc.com/blog/applying-the-80-20-strtegy-in-advanced- manufacturing
Eyushadi (2015) W8_EY_Household Expenses Review by Using Pareto Analysis. GARUDA AACE 2015. https://www.garudaaace2015.wordpress.com/2015/04/09/w_8_ey_household-expenses- review-by-using-Pareto-analysis/comment-page-1/