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Management accounting--decision management: Grahame Steven explains how the identification of Vilfredo Pareto's "predictable imbalance" can help a business to improve its performance.

The Italian economist Vilfredo Pareto derived what has become known as Pareto's law from his studies of income distribution in a number of countries at the turn of the 20th century. He found that roughly 80 per cent of the wealth was held by 20 per cent of the people and that the number of people holding a particular level of wealth fell by a constant factor each time that level was doubled. While his findings were taken as proof by some people of the inequities of capitalism, Pareto predicted that his law of "predictable imbalance" would also apply to communist societies. Studies conducted in the Soviet Union during the Seventies confirmed the accuracy of his forecast.

The law, which identifies the "vital few and the trivial many", has been observed in a wide range of situations. For example, 80 per cent of a tutor's time is taken up by 20 per cent of the students; 80 per cent of interruptions come from 20 per cent of the class; and 80 per cent of decisions in meetings come from 20 per cent of the time.

One of the first uses of Pareto analysis in business was for the purposes of quality management. Joseph Juran, a pioneer of modern quality methods, observed that most quality problems arose from only a few causes. Pareto analysis enabled managers to focus on the problems whose resolution would bring the greatest benefit to the enterprise. For example, IBM found, after analysing computer processing time, that 80 per cent of processing time was concerned with executing 20 per cent of software operating code. As a result, its programmers rewrote the code to make the most frequently used parts of it as streamlined as possible.

Pareto analysis is also a valuable management accounting tool, because it can be applied to a company's customers, products, departments, branches, suppliers, employees and so on to obtain insights with a view to improving efficiency and effectiveness. Consider figure 1, which shows the sales income gained by a company called Customer Focus Ltd (CFL) from each of its 20 customers over the past year. The first step in a Pareto analysis is to sort the customers in descending order according to their sales values; the next step is to calculate cumulative sales; and the final step is to calculate cumulative sales percentages, as in figure 2. While this shows that 73.9 per cent of CFL's sales come from 20 per cent of its customers, its figures can be used to create a Pareto chart to give a more visual representation of the importance of the "vital few". The data can be entered into Microsoft Excel's graphing function to produce plots showing cumulative sales by value or percentage (see figure 3).

Like any management accounting technique, Pareto analysis must be used with care, since it provides only an insight into a particular business issue. Further consideration and analysis is required to determine what action should be taken. Although it is tempting to conclude from this analysis that CFL should stop supplying goods to most of its customers, such a course of action may prove short-sighted. More information is required to determine whether or not a withdrawal strategy is appropriate for these customers. What is the total business available at that company? Is the business expanding? Is CFL part of a larger group?

It wouldn't make sense for the company to stop doing business with large customers to which it currently makes few sales, small customers that are expected to expand their businesses or customers that are part of a larger group. The object of the exercise is to identify customers with poor current and future sales potential. Decisions, made after further analysis, would then be taken based on which customers CFL is prepared to do business with in the future.

[GRAPHIC OMITTED]

Multiple analyses of the same data--sales, contribution and profit--may also be undertaken to provide a more in-depth view of the issue under consideration. A profit analysis, for example, might reveal that one of CFL's major accounts generates little profit. High sales do not always produce high profits, since they may have been obtained by undercutting competitors' prices or offering generous technical support, for example. The company would consequently consider what action it needs to take to improve its profits--for example, seek an above-inflation price increase at the next price review or determine alternative cost-effective methods of providing technical support.

A customer profit analysis for CFL's customers produces the table shown in figure 4. The comparative rankings by sales and by profits in figure 5 provide more insights about the company's customers. Why is B, ranked the second-largest customer in terms of sales, ranked only fourth in terms of profit? Why are customers G and R generating more profits than customer B from lower sales? Why does customer O slip two places when it is ranked by profit? Why do J and P produce losses? The management team would need to investigate these issues and seek some answers. But, before reaching a decision about what should be done with "problem" customers, CFL must consider the potential amount of sales available at these accounts.

[ILLUSTRATION OMITTED]

Pareto analysis can also be used to assess risk in a company. In simple terms, a business's reliance on a small number of customers for 80 per cent of its sales represents a relatively high level of risk, since the loss of a key customer will generally have a greater impact on profits. But it should be remembered that a policy to obtain large contracts with a small number of customers may produce higher profits, because it will create a simpler and more streamlined enterprise. As ever, it's a trade-off between risk and return. Firms may wish to benchmark themselves against their industry averages (if this data is available, for example, from their trade associations) to assess where they stand relative to the competition.

The Pareto approach can be applied to other aspects relating to sales of a company's products--for example, sales by products; sales by distribution channels; customer/product sales by sales representatives; or returns from customers. These analyses can be based on sales, costs, contribution, profit and number of occurrences, so it's important to choose the most appropriate base. For instance, number of occurrences would normally be used to determine which products are returned most by customers and identify the reasons for their return. Sales value could produce a distorted analysis, since a large return that occurred for a "one-off" reason would mask ongoing problems being experienced in relation to other products.

Pareto analysis provides valuable insights because it identifies fundamental aspects of a business issue. But it is important to recognise that it represents only the first step of an investigation. The information yielded by a Pareto analysis must be evaluated further to determine what action should be taken.

P2 further reading

J Avis, C Wilks and L Burke, Management Accounting--Decision Management CIMA Official Learning System (2009 edition), CIMA Publishing, 2008.

Grahame Steven is a lecturer in the School of Accounting, Economics and Statistics at Napier University, Edinburgh.
1 Sales values of CFL's customers

                   Sales
Customer    ([pounds sterling])

A                   14,600
B                2,190,000
C                  905,200
D                1,664,400
E                  262,800
F                  321,200
G                2,044,000
H                  248,200
I                  116,800
J                   43,800
K                  219,000
L                2,978,400
M                  335,800
N                  233,600
0                  277,400
P                   87,600
Q                   29,200
R                1,912,600
S                  540,200
T                  175,200

2 Pareto analysis of CFL's customers

Customer     Sales ([pounds    Cumulative sales          Cumulative
                 sterling])            ([pounds    sales in % terms
                                     sterling])

L                 2,978,400           2,978,400                20.4
B                 2,190,000           5,168,400                35.4
G                 2,044,000           7,212,400                49.4
R                 1,912,600           9,125,000                62.5
D                 1,664,400          10,789,400                73.9
C                   905,200          11,694,600                80.1
S                   540,200          12,234,800                83.8
M                   335,800          12,570,600                86.1
F                   321,200          12,891,800                88.3
0                   277,400          13,169,200                90.2
E                   262,800          13,432,000                92.0
H                   248,200          13,680,200                93.7
N                   233,600          13,913,800                95.3
K                   219,000          14,132,800                96.8
T                   175,200          14,308,000                98.0
1                   116,800          14,424,800                98.8
P                    87,600          14,512,400                99.4
1                    43,800          14,556,200                99.7
Q                    29,200          14,585,400                99.9
A                    14,600          14,600,000               100.0

4 CFL's customer profitability

Customer          Profit
                ([pounds
              sterling])

A                  2,800
B                350,000
C                221,200
D                319,200
E                 67,200
F                 92,400
G                436,800
H                 56,000
I                 33,600
J                 -2,800
K                 19,600
L                506,800
M                 86,800
N                 44,800
0                 50,400
P                 -5,600
Q                  5,600
R                383,600
S                103,600
T                 28,000

5 CFL's customer rankings

Customer          Rank          Rank        Change
              by sales     by profit       in rank

L                    1             1             0
B                    2             4            -2
G                    3             2            +1
R                    4             3            +1
D                    5             5             0
C                    6             6             0
S                    7             7             0
M                    8             9            -1
F                    9             8            +1
O                   10            12            -2
E                   11            10            +1
H                   12            11            +1
N                   13            13             0
K                   14            16            -2
T                   15            15             0
I                   16            14            +2
p                   17            20            -3
J                   18            19            -1
Q                   19            17            +2
A                   20            18            +2

Exam practice

Try the following question to test your understanding. The
answer will be published in the April issue of Velocity, CIMA's
student e-magazine (www.cimaglobal.com/velocity).

CFL's marketing director prepared the following table of total
actual sales and total potential sales to the company's current
and potential customers:

Customer      Potential         Actual
                  sales          sales
               ([pounds       ([pounds
             sterling])     sterling])

A                50,000         14,600
B             2,400,000      2,190,000
C             2,200,000        905,200
D             1,800,000      1,664,400
E               700,000        262,800
F             1,100,000        321,200
G             3,200,000      2,044,000
H               300,000        248,200
I             3,700,000        116,800
J               800,000         43,800
K               300,000        219,000
L             3,200,000      2,978,400
M             2,100,000        335,800
N               250,000        233,600
0               600,000        277,400
P             2,500,000         87,600
Q                50,000         29,200
R             2,300,000      1,912,600
S             1,000,000        540,200
T               200,000        175,200
U               650,000              0
V               450,000              0
W               550,000              0
X             1,250,000              0
Y                50,000              0
Z               750,000              0

You are required to:

A Prepare a Pareto analysis of the potential sales available to
CFL at each account--ie, total potential sales minus actual
sales for each customer. Calculate figures to one decimal place.

B Discuss the results of the analysis prepared for part A. This
discussion must link to the Pareto analyses of sales and
profits prepared for CFUs customers in the main article.
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Title Annotation:study notes
Author:Steven, Grahame
Publication:Financial Management (UK)
Geographic Code:4EUUK
Date:Mar 1, 2009
Words:1870
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