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Thursday, July 21, 2011

ABC Analysis or Pareto Analysis

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Selective Control

Selective control becomes necessary due to constraints of resources of all kinds. Therefore, decision needs to be taken on how much of resources of various types be employed on which specific items from all the given items to maximize the overall gains, benefits or advantages from all the given items.

It means that we do not employ the same equal amount of resources on each and every item that yields benefits or solutions. We become selective. We become selective in giving attention or resources to them or controlling them. On some we apply maximum attention and control because the potential to get maximum benefits seems more in these items. On some others we apply less attention and control since those items offer less potential for gaining benefits. And on the remaining, we apply the least degrees of attention and control as these items hardly provide any scope for gaining advantages.

For arriving at such graded classification, a technique called “ABC analysis” is popularly used. It is statistical technique of decision making and therefore, appears quite scientific and acceptable to a wide cross section of people.

Various Names of ABC Analysis or Similar Techniques

  • ABC analysis
  • Pareto analysis
  • 80/20 rule
  • Vital few, trivial many
  • Principle of factor sparsity
  • VED analysis
  • Managing by exception

Pareto- the Pioneer

Vilfredo Pareto was a 19th century economist who observed in 1906 that 80% of Italy's land and wealth was owned by 20% of the population. He developed the principle by observing that 20% of the pea pods in his garden contained 80% of the peas. Quality management consultant Joseph M Juran suggested the principle and named it after Italian economist Vilfredo Pareto.

The Essence of ABC or Pareto Analysis

Basically, it is a method of classifying items, events, or activities according to their relative importance and deciding on the extent of emphasis, attention and control one should put on such classifications.

We use it for selection of a limited number of tasks or items that produce significant overall effect or benefits. It uses the idea that by doing 20% of work, 80% of the advantage of doing the entire job can be generated. For many events, roughly 80% of the effects come from 20% of the causes.

Over a period of time it has been understood that the figures 20% ad 80% are not sacrosanct. They are indicative and suggest that in place of 20% we should read it as “very few factors” and in place of 80% we should read it as “very large impact” or “very significant effect”. The two factors can be any value “x” and “y” (their values ranging between 0% and 100%) where “x” represents the cause factors and “y” represents the “effect” factor and obviously, the numerical value of “x” is always minimal and that of “y” is always quite large.

It is a formal technique where many possible courses of action are competing for attention. The problem-solver estimates the benefit delivered by each action, then selects a number of the most effective actions (few actions) that deliver a total benefit reasonably close to the maximum possible one (large impact or effect).

It is a creative way of looking at causes of problems because it helps stimulate thinking and organize thoughts. Subsequently the technique helps to identify the top few (up to 20% or so) of causes that need to be addressed to resolve the majority (up to 80% or so) of the problems. It is based on the premise that every situation entails numerous trivial aspects and these need least attention and on the other hand, the vital aspects are few and these need maximum attention yielding maximum benefits. That’s why we also call this technique as “vital few, trivial many”.

Universal Applicability

ABC principle seems to work almost everywhere in every sphere where problem solving and controlling functions are required i.e. in corporations and organizations, business, economy/economics, family, society, personal life etc.

Some examples of it’s wide range applicability are given below:

  • Pareto noticed that 80% of Italy's land and wealth was owned by 20% of the population. He extended his survey to other countries and found that similar distribution applied there to.
  • Distribution of global income is uneven, with the richest 20% of the world's population controlling 82.7% of the world's income. Second rung 20% rich constitutes 11.75% of GDP, third 20% account for 2.30% of world’s wealth, fourth 20% make 1.85% of wealth and the poorest 20% people own just about 1.40% of the entire wealth in the world.
  • The skewed distribution of wealth applies also to subsets of the income range. Even if we take the ten wealthiest individuals in the world, we see that the top three own as much as the next seven put together.
  • Similar distribution pattern is observed in various aspects of businesses of various organizations and corporations as cited below:
    • around 80% of profits come from around 20% of customers
    • around 80% of complaints come from around 20% of customers
    • around 80% of profits come from around 20% of the time spent
    • around 80% of sales come from around 20% of products
    • around 80% of sales are made by around 20% of sales staff
    • by fixing the top 20% or so of the most reported bugs, 80% or so of the errors and crashes would be eliminated
    • In most events, roughly 80% of the effects come from roughly 20% of the causes
    • Inventories of materials held by any store shows this pattern: "A class" inventory will typically contain items that account for 80% of total value, or 20% of total items. " B class" inventory will have around 15% of total value, or 30% of total items. " C class" inventory will account for the remaining 5%, or 50% of total items. Therefore, by controlling a maximum of just about 20% of total items, one can control about 80% value of the money represented by them.
    • By doing 20% of work, 80% of the advantage of doing the entire job can be generated.
    • In terms of quality improvement, a large majority of problems (80%) are produced by a few key causes (20%).
    • Refusing to do business with those 20% of customers who take up the majority of one's time and cause the most trouble can improve the time management situation substantially.
    • Focusing on the 20% of the risks that have the most impact on the project can improve the risk management of the projects.
    • Therefore, many businesses achieve dramatic improvements in profitability by focusing on the most effective areas and eliminating, ignoring, automating, delegating or retraining the rest, as appropriate.
  • ABC or Pareto analysis can be used to arrive at deciding the prioritization of tasks or activities to be carried out also at the personal or family levels. “A” class tasks or activities (say around up to 20% of all the actions to be taken) may yield 80% or more of desired outputs or results.
  • ABC or Pareto analysis can be used to decide on inventory holding levels and purchasing policies and other control actions for the household groceries and other materials or items of expenses that constitute family’s total annual expenses. ABC analysis done on all the items of expenses may show that just about 20% or even less number of items of expenses constitute more that 80% of the total money spent annually.
  • Around 20% of patients use around 80% of health care resources.
  • Around 80% of crimes are committed by around 20% of criminals.

Associated Systems/Techniques

Other systems/techniques that are used in association with ABC analysis are:
  • Quality management: six sigma
  • Problem solving: cause and effect analysis (also called Ishikawa diagram or fish-bone diagram)
  • Inventory management: ABC classification, inventory holding and purchase policies- JIT (just-in-time management)
  • Maintenance management: VED analysis (vital, essential, desirable analysis) for deciding on inventory of spare parts
  • Time management: prioritization of tasks or activities

Example of Use of ABC Analysis: Carry Out "ABC" Classification of Your Monthly, Value Adding and Essential Expenses on Your Consumption Items and Control "A" Class Items of Expenses to Start With

Stage 1

  • Before making list of value adding, essential items of your regular consumptions, make a list of all the non-value adding, non-essential items that you actually bought during the month under review.
  • Against each such item, write down the quantity bought, it's unit price and by multiplying the quantity bought by unit price, you will get your total actual expenses done by you on the non-value adding and non-essential items that you should not have purchased in the first place.
  • Now, make sure that you will not buy these items in future at all. That's your big saving on a recurring basis.

Stage 2
  • Now, make a list of all the (value adding and essential) items of regular consumptions.
  • Against each item, write down as to how many units of each item you consume.
  • Write against each item the unit price at which you buy the item.
  • Find out total expenses in your currency for each item. To do this, multiply the quantity of consumption by the unit price.
  • Arrange the items in the descending order of value (expenses) of each item.
  • Add all these expenses, you will get your total expenditure of the month.
  • Take the first item on the list and work out what percentage of total expenses it forms.
  • Do the same for the second item on the list and for third item and for all the items on the list.
  • You will find that only first 10 or 15 items on the list may account for about 70% to 80% (or more) of the entire expenses on all the items in a month.
  • Concentrate on these 10 to 15 items for controlling the expenditure on them, to start with.
  • Find out ways and means of controlling expenses on these 10 to 15 items and implement them. You will surely save good amount of your money soon.
  • Good luck!!

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