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 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.
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.
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|
|Publication:||Financial Management (UK)|
|Date:||Mar 1, 2009|
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