Internal audit and the pareto diagram.

Internal auditors are increasing their use of data analytics to better understand process characteristics, isolate issues and perform more accurate root cause analysis. This proliferation of data and its analysis raises issues because internal auditors can spend too much time trying to navigate the tsunami of data or unwittingly focusing on minor items at the expense of more important ones.

A Pareto Diagram is a two-axis chart that contains both bars and a line graph. The individual values are plotted against the left vertical axis and are represented by bars in descending order.  The frequency of occurrence of the item being analyzed is plotted and may include errors, costs, shipments, etc. The cumulative total (percentage) is represented by a line and it is plotted against the right (second) vertical axis.   

Pareto Diagrams are related to the 80/20 principle, which states that 20 percent of the sources cause 80 percent of the problems. For internal auditors, this principle essentially means that there is a concentration of sources that should identify the best focus points for maximum results, help to prioritize issues and focus on the solutions that provide the largest value for money. The Pareto Diagram highlights the most important factors and often represents the most common sources of defects, for example, the highest occurring type of defect, or the most frequent reasons for customer dissatisfaction.

Pareto Diagrams show the relative importance of issues in a simple visual format that is quick and easy to prepare.

How to Prepare a Pareto Diagram

  1. Decide what categories will be used to group the data. These are the causes or problems that will be examined, compared or ranked through brainstorming or with existing data.

  2. Decide the measurement that will be used (e.g. frequency of occurrence, amount/quantity, time, cost). Choose the most meaningful unit of measurement. Since it is sometimes unclear which unit of measurement is best, you may need to do more than one (e.g. frequency and cost).

  3. Decide the time period that will be covered (e.g. one day, week, month, quarter, year).   Choose a time period that is long enough to represent the solution, remembering that longer time periods don’t always result in better information. However, make sure it is long enough to account for seasonality or different patterns within a day, month or longer intervals.

  4. Arrange the data based on the categories selected in Step 1 above and calculate the totals for each of them.

  5. Arrange the sub-totals for each category in descending order from left to right.

  6. Calculate the percentages for each category, where each subtotal for that category is divided into the total for all categories.

  7. List the problem categories on the horizontal (x) axis and frequencies on the vertical (y) axis. Draw the chart where the subtotals are graphed against the left vertical axis, and the cumulative percentages are plotted against the right vertical axis.  (Note: All subcategories must total the sum for the data analyzed, and the percentages must total 100 percent.)

  8. To interpret the results, the tallest bars generally indicate the biggest contributors to the overall problem. Dealing with, and solving, these problem categories first makes sense, but the most frequently occurring item may not be the most important, or the most expensive. So internal auditors and their clients should always ask which items have the most impact on the goals of the organization and related stakeholders.

The following illustrative questions help to drive the thought (and analysis) process:

    • What is the problem people are having?

    • Which items, based on the knowledge of process owners, accounts for most of the manifested problem and will be most impactful in solving it?

    • By running a cumulative total, what are the categories that when added together add up to 80 percent of the total? 

Pareto Diagram are designed to organize data and can be used to prioritize improvement efforts by focusing on major root causes of the problems under review. The focus is to focus on cause and effect relationships. 

They can be generated in software applications like Microsoft Excel, Tableau, specialized statistical software tools, and quality charts generators.

The following diagram is an example of a Pareto Diagram constructed using Excel and its two vertical axis feature. It shows the number of errors by type as bar charts and the cumulative percentage as a line against the second y-axis. Note that to lower the number of errors by 77 percent, it only requires solving the first three issues.

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Pareto Diagrams help to prevent a common issue caused when problem-solvers fail to identify all contributing causes to a problem.  By only addressing some of the contributing causes, they unwittingly shift the problem by removing some of the causes, but ignoring or worsening others.

A useful technique to show the value provided to the organization is to draw before and after Pareto Diagrams. This is done by showing the original diagram and next to it, the effect of the changes adopted to correct the original problem.

Another technique to help internal auditors provide benchmarking information is to collect data from different departments, locations or units, and present the results in side-by-side diagrams.

These Pareto Diagrams can help internal auditors focus on the problems, and solutions, that offer the greatest potential for improvement. They show the relative frequency of the issues and corrective actions displayed so the internal audit team can focus on those causes that will have the most significant impact when solved. 

Interested in learning more about this and other tools and techniques? Join Dr. Murdock when he teaches Lean Six Sigma Skills for AuditorsInternal Audit School, and High-Impact Skills for Developing and Leading Your Audit Team. 

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