>studynotes

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 causes. Pareto analysis enabled managers which shows the sales income gained by a
derived what has become known as to focus on the problems whose resolution company called Customer Focus Ltd (CFL)
Pareto’s law from his studies of income would bring the greatest benefit to the from each of its 20 customers over the
distribution in a number of countries at the enterprise. For example, IBM found, after past year. The first step in a Pareto analysis
turn of the 20th century. He found that analysing computer processing time, that is to sort the customers in descending
roughly 80 per cent of the wealth was held 80 per cent of processing time was order according to their sales values; the
by 20 per cent of the people and that the concerned with executing 20 per cent of next step is to calculate cumulative sales;
number of people holding a particular level software operating code. As a result, its and the final step is to calculate
of wealth fell by a constant factor each time programmers rewrote the code to make the cumulative sales percentages, as in figure 2.
that level was doubled. While his findings most frequently used parts of it as While this shows that 73.9 per cent of CFL’s
were taken as proof by some people of the streamlined as possible. sales come from 20 per cent of its
inequities of capitalism, Pareto predicted Pareto analysis is also a valuable customers, its figures can be used to create
that his law of “predictable imbalance” management accounting tool, because it a Pareto chart to give a more visual
would also apply to communist societies. can be applied to a company’s customers, representation of the importance of the
Studies conducted in the Soviet Union products, departments, branches, “vital few”. The data can be entered into
during the Seventies confirmed the suppliers, employees and so on to obtain Microsoft Excel’s graphing function to
accuracy of his forecast. insights with a view to improving efficiency produce plots showing cumulative sales by
The law, which identifies the “vital few and effectiveness. Consider figure 1, value or percentage (see figure 3).
and the trivial many”, has been observed in
a wide range of situations. For example, 2 Pareto analysis of CFL’s customers
80 per cent of a tutor’s time is taken up by
20 per cent of the students; 80 per cent of Customer Sales (£) Cumulative sales (£) Cumulative sales in % terms
interruptions come from 20 per cent of the L 2,978,400 2,978,400 20.4
class; and 80 per cent of decisions in B 2,190,000 5,168,400 35.4
meetings come from 20 per cent of the time.
G 2,044,000 7,212,400 49.4
One of the first uses of Pareto analysis in
business was for the purposes of quality R 1,912,600 9,125,000 62.5
management. Joseph Juran, a pioneer of D 1,664,400 10,789,400 73.9
modern quality methods, observed that C 905,200 11,694,600 80.1
most quality problems arose from only a few S 540,200 12,234,800 83.8
M 335,800 12,570,600 86.1
1 Sales values of CFL’s customers F 321,200 12,891,800 88.3
Customer Sales (£) Customer Sales (£) O 277,400 13,169,200 90.2
A 14,600 K 219,000 E 262,800 13,432,000 92.0
B 2,190,000 L 2,978,400 H 248,200 13,680,200 93.7
C 905,200 M 335,800 N 233,600 13,913,800 95.3
D 1,664,400 N 233,600 K 219,000 14,132,800 96.8
E 262,800 O 277,400 T 175,200 14,308,000 98.0
F 321,200 P 87,600 I 116,800 14,424,800 98.8
G 2,044,000 Q 29,200 P 87,600 14,512,400 99.4
H 248,200 R 1,912,600 J 43,800 14,556,200 99.7
I 116,800 S 540,200 Q 29,200 14,585,400 99.9
J 43,800 T 175,200 A 14,600 14,600,000 100.0

50 financial management
 PAPER P2

Like any management accounting 4 CFL’s customer profitability 5 CFL’s customer rankings
technique, Pareto analysis must be used
with care, since it provides only an insight Customer Profit (£) Customer Profit (£) Customer Rank Rank Change
into a particular business issue. Further A 2,800 K 19,600 by sales by profit in rank
consideration and analysis is required to B 350,000 L 506,800 L 1 1 0
determine what action should be taken. C 221,200 M 86,800 B 2 4 -2
Although it is tempting to conclude from G 3 2 +1
D 319,200 N 44,800
this analysis that CFL should stop supplying
E 67,200 O 50,400 R 4 3 +1
goods to most of its customers, such a
course of action may prove short-sighted. F 92,400 P -5,600 D 5 5 0
More information is required to determine G 436,800 Q 5,600 C 6 6 0
whether or not a withdrawal strategy is H 56,000 R 383,600 S 7 7 0
appropriate for these customers. What is M 8 9 -1
I 33,600 S 103,600
the total business available at that
J -2,800 T 28,000 F 9 8 +1
company? Is the business expanding? Is
CFL part of a larger group? O 10 12 -2
It wouldn’t make sense for the company Multiple analyses of the same data – E 11 10 +1
to stop doing business with large customers sales, contribution and profit – may also be H 12 11 +1
to which it currently makes few sales, small undertaken to provide a more in-depth view N 13 13 0
customers that are expected to expand of the issue under consideration. A profit
K 14 16 -2
their businesses or customers that are part analysis, for example, might reveal that one
of a larger group. The object of the exercise of CFL’s major accounts generates little T 15 15 0
is to identify customers with poor current profit. High sales do not always produce I 16 14 +2
and future sales potential. Decisions, made high profits, since they may have been P 17 20 -3
after further analysis, would then be taken obtained by undercutting competitors’ J 18 19 -1
based on which customers CFL is prepared prices or offering generous technical
Q 19 17 +2
to do business with in the future. support, for example. The company would
A 20 18 +2
3 CFL’s cumulative customer sales by percentage
consequently consider what action it needs
to take to improve its profits – for example,
100% seek an above-inflation price increase at the
next price review or determine alternative
90% cost-effective methods of providing
technical support.
80% A customer profit analysis for CFL’s
customers produces the table shown in
70% figure 4. The comparative rankings by sales
and by profits in figure 5 provide more
60%
insights about the company’s customers.
Why is B, ranked the second-largest
50%
customer in terms of sales, ranked only
fourth in terms of profit? Why are customers
40%
G and R generating more profits than
customer B from lower sales? Why does
30%
customer O slip two places when it is
20%
ranked by profit? Why do J and P produce
losses? The management team would need
10% to investigate these issues and seek some
answers. But, before reaching a decision
0% about what should be done with “problem”
L B G R D C S M F O E H N K T I P J Q A customers, CFL must consider the potential
amount of sales available at these accounts.

financial management 51
>studynotes PAPER P2

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 Customer Potential Actual

sales (£) sales (£) sales (£) sales (£)
A 50,000 14,600 N 250,000 233,600
B 2,400,000 2,190,000 O 600,000 277,400
C 2,200,000 905,200 P 2,500,000 87,600
D 1,800,000 1,664,400 Q 50,000 29,200
E 700,000 262,800 R 2,300,000 1,912,600
F 1,100,000 321,200 S 1,000,000 540,200
G 3,200,000 2,044,000 T 200,000 175,200
H 300,000 248,200 U 650,000 0
I 3,700,000 116,800 V 450,000 0
J 800,000 43,800 W 550,000 0
K 300,000 219,000 X 1,250,000 0
L 3,200,000 2,978,400 Y 50,000 0
M 2,100,000 335,800 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 CFL’s customers in the main article.

Pareto analysis can also be used to company’s products – for example, sales by recognise that it represents only the first
assess risk in a company. In simple terms, products; sales by distribution channels; step of an investigation. The information
a business’s reliance on a small number of customer/product sales by sales yielded by a Pareto analysis must be
customers for 80 per cent of its sales representatives; or returns from customers. evaluated further to determine what action
represents a relatively high level of risk, since These analyses can be based on sales, should be taken.
the loss of a key customer will generally costs, contribution, profit and number of
have a greater impact on profits. But it occurrences, so it’s important to choose the Grahame Steven is a lecturer in the
should be remembered that a policy to most appropriate base. For instance, School of Accounting, Economics and
obtain large contracts with a small number number of occurrences would normally be Statistics at Napier University, Edinburgh.
of customers may produce higher profits, used to determine which products are
because it will create a simpler and more returned most by customers and identify the P2 further reading
streamlined enterprise. As ever, it’s a trade-off reasons for their return. Sales value could
between risk and return. Firms may wish to produce a distorted analysis, since a large J Avis, C Wilks and L Burke,
benchmark themselves against their industry return that occurred for a “one-off” reason
averages (if this data is available, for example, would mask ongoing problems being
Management Accounting –
from their trade associations) to assess where experienced in relation to other products. Decision Management CIMA
they stand relative to the competition. Pareto analysis provides valuable insights Official Learning System (2009
The Pareto approach can be applied to because it identifies fundamental aspects of edition), CIMA Publishing, 2008.
other aspects relating to sales of a a business issue. But it is important to

financial management 53