Pareto Principle (the 80/20 rule)

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The Pareto Principle is a fundamental principle in management theory. Invented by Italian economists Vilfredo Pareto and Giuseppe M. Perricone in 1907, the Pareto Principle states that most large manufacturing firms can be found in large sections of towns which have small population centers. According to this theory, if a firm produces in lots of towns but has relatively little population in the outlying areas, it will be adversely affected by the market forces. If it manufactures in lots of small towns but has large population centers, its share of market sales increases and it will prosper. In this way, according to the Pareto Principle, the location of manufacturing firms determines the market shares they enjoy. The concept of Pareto analysis has various other uses, such as determining the optimum locations for organizations within a firm, the effect of regional differences on sales, the location of highly profitable or risky ventures, the location of new manufacturing plants, and many others.

To explain the Pareto Principle in a better way, the term "pareto" means "even", "little", or "big" in Italian. The idea behind the Pareto Principle is that large firms must either consume a larger percentage of the available production or lose a larger share of their total sales. For instance, if a company makes cars whose price is $10 a piece and sells them for $20 a piece, then it's not surprising that only 20 percent of sales goes to the customer. The reason is that car makers need to distribute their products equally in order to make any profit. They must sell even smaller quantities to get high enough prices so that their overhead costs aren't too high and their profits are high enough.

A company that makes widgets may use a different accounting method, say the line item method, to determine its manufacturing costs. It would be much easier to determine the unit cost of its widgets rather than its revenue share because the line item method will normally require the manufacturer to sell all its products in a relatively small quantity. That kind of a distinction between revenues and expenses is referred to as gross margin. If a company has a relatively low gross margin, its net profit margin is typically small. Its gross profit margin is usually a good measure of the price a company is willing to pay for a widget or its ability to sell a widget at its retail price. It is the difference between the manufacturer's cost of production and its cost of sale.

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