Would you be interested in knowing a way to increase your business by 16 times! Got your attention? The following material, about the 80/20 Rule, gives an insight into how this is possible.
Introduction to The 80/20 Rule
In 1897, Italian economist Vilfredo Pareto (1848-1923) first articulated what has become known as the 80/20 Rule.
We think this basic concept is one of the most powerful tools available to business owners. It should become part of your every day thinking when managing your business and your life.
Koch in his 5 star book The 80/20 Principle (Koch, 1997) [see also The 80/20 Individual (Koch, The 80/20 Individual, 2003) ] sums up the Rule as:
“The 80/20 Principle asserts that a minority of causes, inputs or effort usually lead to a majority of the results, outputs or rewards. Taken literally, this means that, for example, 80 percent of what you achieve in your job comes from 20 percent of the time spent. Thus, for all practical purposes, four-fifths of the effort – a dominant part of it – is largely irrelevant. This is contrary to what people normally expect.”
This implies that:
- 80% of your problems will come from 20% of the people
- 80% of your sales will come from 20% of your products
- 80% of your time produces 20% of your gain and conversely, 20% of your time produces 80% of your gain.
Let’s turn here to several practical examples of how the Rule can work for you and magnify your productive results.
Where to Optimise
Our goal in introducing the 80/20 Rule into our business is to do less of most things but more of the most important things. As discussed elsewhere, that focus can lead to something in the order of a 16 times improvement in your business with little extra input of effort or other resources.
Typically we could be looking at optimising one or more of the following:
- Reduce property and fixed assets allowing the business to be more flexible and “virtual”.
- Decrease the size of the business to its most profitable core, letting go some of the less profitable and perhaps legacy elements of the business.
- Reduce the number of points in the value chain that business tries to operate in. For example, if you manufacture sub assemblies and then the final assembly and run wholesale and retail operations, there might be some steps that you can remover
- Rather than being all things to all people, focus particularly on the things you can do well and where you have a competitive advantage in.
- Focus on the customers that have the most importance to your business; either by the amount that they purchase or the price that they are prepared to pay. Other customers remain important but you may need to manage them in a way that is less time consuming so as to make them more profitable. If you lose some in the process, so be it because they are not as important as your major customers
- Reduce the number of suppliers that you have to those that have your most important products, at your best price, and who are reliable and timely suppliers. This allows you to potentially to reduce your inventory considerably and streamline your supply chain.
- Consider letting some of the employees who are less productive than others go. This might be individual employees or it may be a particular group of employees whose function you choose to outsource.
Most people intuitively think that more effort produces more reward in a fairly linear fashion. So, spending $100 on marketing might result in $1000 more in sales; $200 on marketing in $2,000 in sales and so on.
The 80/20 Rule says that spending $100 on marketing to the right target group could result in $4,000 in return. Why is this? Consider if your marketing is ‘shotgun’ and targets everyone equally, many of them are not good candidates as they have no need of your product or can’t afford it and so on. Therefore your result is the average of that shotgunned population. On the other hand, if you only marketed to those that wanted your product and could afford it, your sales are naturally going to be much more for the same dollar investment.
When I ran a florist networking business, some 67% of the order volume came from 20% of the florists. I realise that the numbers are a bit different but the principle certainly applied. We called these florists “TPCs” (for Top Twenty Percent) and focused our marketing and customer service on them. After all, the loss of one of these florists to a competitor was the equivalent of losing 8 average florists. Staff were trained to look after them well and to pay special attention to any grievances and suggestions they had.
Conversely, recruiting just one new florist in our TPC bracket was the same as recruiting 8 ordinary florists. Because it wasn’t 8 times more expensive to recruit a TPC, we were ahead financially. As well, every one we recruited had the impact of costing our competitors the equivalent of 8 florists as well.
While competitors might have been fixated on the boasting rights associated with having the most florists, we could be just as profitable (and were) with just half their florists because ours were selected for earning’s power.
The moral of the story is that you should work out which customers lead to your greatest marketing gains and set out to focus your resources on them first leaving the not so profitable to be mopped up later.
I bet you would agree that comparatively few of your customers cause you most of your problems and heartache.
Most of your customer complaints will come from a few customers. Consider firing those customers. But, you must first consider if this vocal minority are telling you something that the silent majority also don’t like about your business but won’t tell you. All change for the good comes from someone upsetting the traditional apple cart so you build a new and better apple cart. Same with people who give you constructive criticism. They are very valuable.
Many of your small customers will make disproportionate demands on your time. If it takes the same time to serve a small client as it takes to serve a large client you would clearly be better off to focus on the large clients as your gains will be disproportionately better. If you rank all your customers by size and keep dropping off small ones, your average sale will automatically increase without much more effort on your part.
When you rank your existing customers by their profitability, you will quickly see that comparatively few of them contribute most of your profitability. You will also find a surprising number of them probably cost you money when you consider the amount of staff time required to service them and their low sales volume. Retiring some of those customers or putting them on a lower cost of service can improve your overall profitability.
It is also very tempting to go outside looking for more customers. While this is an excellent strategy, it should not be taken at the expense of undercapitalising on your existing customers.
It is going to cost a great deal more to find and grow a new customer than it is to maximise the sales from an existing customer.
Do you find comparatively few of your suppliers cause the majority of supply and quality problems. This is the 80/20 Rule at work.
You could get rid of a lot of your supplier problems by simply ceasing to trade with those suppliers. The Rule would indicate up to an 80% reduction in problems from firing and/or replacing as little as 1 in 5 of (20%) of your suppliers. In a previous florist network business, we used to ‘fire’ any florist who was regularly rude or abusive on the phone to our call centre staff. The staff were permitted to recommend who should be ‘fired’ and we usually followed their lead. We probably only did this 15-20 times over the years but the effect on morale because the staff knew they could do this was very considerable. Everyone knows the old saying ‘A few bad apples spoil the lot’.
You may have more than one supplier for each product or each family of products. Each of these suppliers takes a certain amount of overhead time and resources to service. They will not be providing similar levels of service. It is therefore a worthwhile practice to rank your suppliers for each of your product line by their contribution to optimising your business.
It may be that price alone is not the most important determinant of the quality of a supplier. The supplier who offers a cheap price but is regularly out of stock of some important component of your business if a false asset to your business. On the other hand, if a supplier requires you to buy large quantities of product and store them as inventory in your business, the cost of tying up your cash in that inventory may in fact mean that that supplier is more expensive to you than a supplier that charges more but requires you to stockpile less and who can supply any outages that you have rapidly.
Your business will only make money when it sells a product and if that product is in short supply or out of stock in your business you are not making money. (see Cost of over and under stocking article). Worse, if your customer has to go elsewhere to find that product they may well continue to purchase the rest of their supplies from another company and thereby you lose that customer , because your supplier is not able to service you as well as you would wish.
For their part, you are a customer to them. They want to grow you as a customer and understand they need to provide you with an attractive service. If you can offer more business to them, you would automatically become more mportant to them and therefore get more attention from them when necessary.
Not all staff are equally productive and valuable. Elsewhere we discussed being aware of the Normal Distribution when Choosing professional advisors. There we pointed out that about 15% of advisors are hopeless (very close to our 20% we are talking about here) and 15% are exceptional and 66% are average. When dealing with people, there will be comparatively few best people in your business that are key players. Hopefully most of your senior management team lies in this area but in the words of the song; “it ain’t necessarily so”. Also, there will probably be a few technical experts or specialists in their particular skill. Many of the others will be “holding the fort”.
Consider the impact the 15-20% of poor staff are having on your company productivity and staff morale. Maybe you should be firstly trying to show them how to lift their game and, failing that, letting them go. The remaining staff will thank you for getting rid of the deadwood and your average productivity will go up as the low producers improve or are moved on.
Conversely, the 15-20% who are the most productive clearly deserve some recognition – especially if you want to keep them.
Possibly as a first pass in your organisation, you can give thought whether you need entire sections of your operation.
Do you, for example, need a HR Department, do you need IT staff, do you need accounting staff. Many of these specialist skills can be outsourced and one advantage of outsourcing is that if they don’t perform well you can
let them go. Another advantage is that you will be outsourcing to a specialist who will presumably do the job better in many ways than your own staff may be able to. They might be better equipped to scale as your business grows rather than taking on new staff – of whom 80 percent will be average at best. It’s also true to say that you may not have sufficient skills within yourself or your business to adequately determine whether your existing staff in those roles are doing the best possible job. When you outsource, you should be getting the best skills that you can afford and almost certainly do better than keeping that skill in-house. You will also be faced from time to time with a need to replace staff that leave and the necessary training and other activities to bring the new people up to speed. If you outsource, that is the job of the outsourcing company to bring people up to speed and provide you with a steady level of service irrespective of fluctuations in their own staffing.
You can consider the efficiency of your staffing operation by calculating a ratio “return on employment” which is calculated by dividing your revenue by the cost of your labour.
This won’t have a great deal of information the first time you do it but if you continue to do it periodically – perhaps 6 monthly – you will see a trend: either the return will go up or it will go down. If it goes up then you are generating more return with less salary expense and this is a good thing. If on the other hand it falls, then you are plugging in more labour and not getting a corresponding return in the revenues. When calculating this, include both your in-house salaries and any outsourced labour related costs. If you have a reasonably large organisation, you can do this on a departmental basis. This will indicate the departmental return on the money and other assets involved in operating it, A return on labour ratio will indicate the departments that are the most efficient users of labour. This is only practical when the department has direct revenue from sales of some sort. Trying to give e.g. the accounting department revenue by ‘charging’ other departments is the stuff of cost accounting nightmares and is a world we don’t want to enter because the work is hugely time consuming and the results are guesswork largely.
Elsewhere we have discussed the Boston Consulting Growth Share Matrix with revenue growth on one axis and market share on the other. (see Boston Consulting Group Growth Share Matrix article) We wrote there of the great businesses to have (the ‘Stars”) and the terrible ones to have (the “dogs”). It might be possible to plot return on labour BCG Matrix format. This would indicate to you, those departments that are your “stars” and “dogs”.
We have been discussing the usefulness of applying 80/20 to your personnel. It is important not to take this too far! We may also have given the impression that you can drop 80% of your staff. This is not necessarily the case. Consider a hamburger which may be 20% meat which is the part that is most attractive and most nutritious. But without the surrounding bread roll (the 80%), it is not a hamburger and may not be much of a meal. Most likely you will require and should have these additional staff. The trick with the 80% component of your staff is to keep them focused as much as possible on productivity. Very often this means providing optimal systems for production and training them to follow these systems.
You personally are only going to have strengths in some areas. In a well run business, you will hire others who complement your weaknesses in order to give a well rounded business. Therefore businesses can and should be run as a team of talented individuals.
Occupational Health and Safety
If you work on reducing the risk to your business and people by looking into occupational health and safety, you will quickly find a comparatively few situations (dare we say 20%) cause most of the problems. By fixing them first, you will have the fastest reduction in safety risks. See the 80/20 Rule applied to risk in the Risk Management Systems Recipe .
Lean Management and Six Sigma are techniques for improving productivity.
If you get into them, you will quickly find that they focus heavily on removing ‘outliers’. These are the comparatively few (say 20% for example), events and processes that lie outside the average and which cause most of the problems with productivity.
If you rank the sales of each of your products starting with the best sellers, you will quickly find that comparatively few of them add up to the largest proportion of your sales.
Consider pruning the low selling items on a regular basis and trying to find more products like the big selling 20% products. On the face of it, removing 8 out of 10 of your products with associated production, marketing and retailing costs will only reduce your income by 2 tenths but remove 8 tenths of your costs – leaving you much better off.
Interestingly, there is a quite legitimate business strategy called the ‘long tail’ (Google it) which says quite the opposite to the 80/20 Rule. In this case you actually make a viable business from stocking a hugely greater range of product rather than shrinking it. The success of Apple’s iTunes demonstrates there is a place for this strategy.
When looking for directions in which to take your business to make it more productive, one can look at what has happened with other industries and in your own where there have been exceptionally successful businesses, this is discussed in more detail in the well known book on strategy, “Blue Oceans.”
Taking a page out of the BCG Matrix (see Boston Consulting Group Growth Share Matrix) rank all the possible alternatives to take your business forward on two dimensions; the likely return and the likely effort. Create a 4 cell matrix. The cells will be “low return, low effort”, “high return, low effort”, low return, high effort” and “high return, high effort”.
Anything that scores well in the cell that represents lower effort and higher return are the ones to start with. The others can follow along in ever diminishing order of impact. In fact, you will likely never execute all of the options because most of the gain will come in the 20% of alternative strategies in the “high return, low effort” cell (the BCG “stars”).
You certainly are not going to implement any of the badly ranking “dogs” cell opportunities!
You may consider acquiring a new business that is similar to your own or in a complementary area. This may or may not be a good idea.
If the business is not in a very healthy condition, and if you have managed to optimise your own business (see e.g The Amagin and TOC articles), then acquiring this one and optimising it may lead to significant capital gains and improvements in your operating scale. This would always be subject to the purchase price being a reasonable value on the business.
On the other hand, if the business is of a similar quality as your own, it may well be that acquiring it without the opportunity to streamline it, is not a very productive return on the investment of your time and money.
If the business is in a complementary sector, its purchase may help to develop your own business but it is also quite probable that it will drain time and money from your own business while you learn how to operate in this new industry sector. If the business does seem to offer some advantage to you, perhaps a strategic alliance with that complementary business may be better than a purchase.
Growth by acquisition often looks attractive to owner-operators because buying things is a lot easier psychologically than selling some of the things that you have put together in your business and may have a sentimental attraction towards.
But if the acquisition can’t be streamlined or if you choose to streamline it before your own existing business, you will simply be adding more of the same level of overheads and distractions from the new business that you already have in the old business. This has the effect of doubling the demands on your time and money and other resources without necessarily a complementary increase in profitability.
The Rule says that 80% of your time in a day will be taken up with less productive work.
Imagine how much further you could move your business if you could use your time more productively. Time wasting things like business travel, meetings and report writing would be pruned mercilessly. My floral business ran in 3 countries. Imagine how much time my staff and I could have wasted travelling. In fact we did very little but focused on building phone relationships with those florists who made a difference (80/20) and our business did very well.
Another lesson that might be a bit of a struggle for many to agree with is the concept that ‘close enough may be good enough’.
If you accept the 80/20 Rule, most of what you are going to do will be achieved with just 20% of the effort. All the rest has a steadily declining payoff. It might therefore make some sense to not bother finishing the job to perfection but to move on when most of it is done.
Clearly this is not going to be a very practical solution for medical surgery or the construction of high rise buildings!
But maybe it can be for such things as software. Ask yourself how many of the hundreds of options in Word or Excel you use and wonder if you could happily get by with a simpler, cheaper, product. If you could produce a product much more cheaply and faster than a competitor because you only focused on the functions that the majority of people want, would you be more profitable than the competitors. To consider the power of this, look at the simplicity of Apple’s iPod, iPhone and iPad devices. They are much simpler in terms of functions than their competitors but hugely successful.
When you are negotiating with another party, there are probably only comparatively few things you are most passionate about. It will be the same for them.
Most of the rest of the issues can be passed over quickly but you can bet both parties will want their important 20% of issues addressed before the deal is done.
There is no real need to spend a lot of time exhaustively going through every issue – and probably thereby encouraging new issues where before they was none. It is common to hear that two parties reached agreement quickly by addressing the most important issues for both parties only to have the lawyers stall things by fighting about a whole host of other issues only peripherally important to the two players.
The other thing to remember in a negotiation is that things will race along at the start when you are addressing the 80% that neither party thinks are too important but will become increasingly complex and possibly time consuming as you get to the comparatively few ‘deal breaker’ issues for each party.
Goal setting (covered in our Goal Setting Recipe article) is all about focusing on the most important issues in order to get ahead as quickly as possible.
In that regard, the 80/20 Rule and Goal Setting are siblings and can be read together.
There are probably comparatively few things that you need to do to get the most pleasure from life.
You can therefore get the most from life by making sure you do as much of these comparatively few things as you can before you start to do other things that are not as enjoyable.
Eggs in a Basket
Well known investor Warren Buffet tends to hold comparatively few shares for long periods of time. He has carefully selected these (say) 20% of shares to be 80% of his portfolio because he has observed he gets the best return from them.
Compare this with the average investor who buys on impulse and ‘hot tips’ and rarely does nearly as well.
By putting all his money onto a few eggs in the basket and then watching the basket very carefully, Buffet greatly reduces the work he has to do, the investment risk he faces and manages to do very well financially.
You might be able to achieve similar results by consciously downsizing your business by focusing on fewer, better, customers, products and suppliers and then watching them like a hawk.
The 80/20 rule is not just a one time wonder. It is what is known as a fractal meaning that it keeps repeating itself as you drill down.
So, if you take a town of 50,000 people, 20% (10,000 people) of them will have 80% of the wealth in the town. But, 20% of those 10,000 wealthy people will have 80% of all the wealth of the 10,000. So 2,000 people have 80% of the 80% of the wealth.
=This is borne out by economic reach as demonstrated by this quote from the Guardian newspaper.
Wealth inequality in the US is at near record levels according to a new study by academics. Over the past three decades, the share of household wealth owned by the top 0.1% has increased from 7% to 22%. For the bottom 90% of families, a combination of rising debt, the collapse of the value of their assets during the financial crisis, and stagnant real wages have led to the erosion of wealth.
The share of wealth owned by the top 0.1% is almost the same as the bottom 90%
What does this mean for you?
It means if you keep narrowing your focus and drilling down through several layers of the 20% market share, you will be tapping into increasingly fertile markets. So, don’t stop with just one 80/20 pass though your market.
If you plotted this on a graph it would look like the skew curve on the following graph.
Once you know that ten people will buy 1 unit of your product, you can also see that 1 person will buy a whopping 6.25 more times, 3 will buy 5 times more and 30 or more will buy half (a total of 15 units) as much if you had a cheaper, no frills version. If you are not alert, and have just the one price point on your product, you will cater for the 10 people but miss the ones willing to pay a lot more and the 15 units you can see to those only willing to pay a lower price. Car manufacturers have known this for years and offer a range of cars from cheap to luxury – with declining sales, but increasing profits, as the cars get more expensive.
To have a play with numbers, go to the Perry Marshall Power Curve website
16X Results by Customer Focus
You already know that out of every 100 customers you have, a predicted 20% (20) will buy 80% of your services. Let’s say these big ones are buying $1,000 of product a month so their total purchases are $20,000 a month.
As this is 80% of your sales, we know the total sales per month is $25,000 and that the 80 smaller buyers share the remaining $5,000 between themselves and so average $5,000/80 or $62 in sales each. The big buyer is buying ($1,000/$62=16) 16 times (16X) more than the small buyer.
Let’s assume that the same amount of sales resources is required to make a sale to either a big buyer or a small buyer.
Twenty units of sales resources applied to the big buyer yields 80% of the sales reward or (80/20=4) 4 sales units for each sales resource unit .
Eighty units of sales resources to the small people yields 20% of the sales or (20/80=0.25) 0.25 sales units for evry sales resource unit consumed.
The return from the big buyers is (4/0.25=16) 16 times more for the sales resources consumed.
Which people should you focus your sales resources on do you think? Clearly the big people yield 16 times the result that the small people do so they are the best for focus on – or at least make sure they are serviced as well as possible before you turn to serving the smaller buyers.
You may argue that the 80/20 does not apply exactly. Your results are more like 75/25 for example. But, applying the same logic as above, the big people are still 9 times better than the small people. If you are very skewed the other way and have a 90/10 ratio, the big ones are worth 81 times what a small one is worth to you.
If the units of sales resources required for the big buyers is more than for the small buyers, the 16X will be different. Let’s assume it takes double the sales resources to sell to a big buyer. That means 40 units of sales energy to each of the 20 big buyers or 2 sales units per sales resource unit. The small buyers have not changed so the math is (2/0.25=8) and the multiplier falls to 8X rather than 16X; but nevertheless a big difference.
If the price you can charge the big person is less than the small person due to e.g. quantity discounts, the 16X will also change but the discount would have to be very high (and it can never be too large or you are selling below cost) to bring the big buyer down to the small buyer in terms of their importance to you.
If you are not allocating your sales resources to service the big customers, and to find new big ones, you are forgoing a lot in possible sales.
If 20% of your sales resources are bringing in 80% of the sales from the big customers, you may be able to afford to ‘fire’ the small customers, reduce the size of your sales force and not be too much worse off. Or better possibly, ‘fire’ the small customer requiring the same service level as the big customer and divert the sales resources to finding more big customers,
Something like this might encourage you to move from having a labour consuming shop front to a warehouse operation which still services your big customers but discourages the less attractive smaller customer.
16X Results by Product focus
If you agree with the discussion above, we can see that the same logic applies to your product mix.
Twenty percent of your product will be 80% of your sales; measured either in volume or in return – it works both ways.
Therefore these 20 big selling items return 16X what the 80 small sellers do.
The effort in ordering small selling items is likely to be similar to that for large selling items b.ut for much less return.
You might consider continuously dropping small selling items off your list to focus on big selling ones. You might keep trying to introduce new products that your big buyers might want and see if they work out as big selling product lines (keepers) or small sellers (to be discarded).
If you want to know more about how to show the 80/20 effect visually on charts, you can read up about Pareto Charts in (e.g.) MS Excel and a host of other sources. These will show you how to plot results onto a graph and how to interpret the results meaningfully.
Becoming a 80/20 Black Belt
Even if your are smitten with the 80/20 concept as we are, putting it into practice takes a lot of willpower because there are just so many dimensions that you can work on at any one time;
- save time
- sell more
- fewer staff
- better lifestyle and so on
Pretty quickly, you get paralysed wondering which way to go next or start losing productivity by multitasking (see Multitasking Tool).
Why not apply 80/20 to your options and focus on the one that comes to the top of the pile as pay back for resources applied to it?
How about training staff to apply 80/20 ail the time as the whole business moves as quickly as possible.
Alternatively, consider finding the ‘contraint’ in your operations and applying 80/20 attention there for maximum effect (see Theory of Constraints (TOC) )
If you find the 80/20 principle a bit hard to stomach, you could get started with its relative: the 50/5 principle.
This says that typically 50% of the company’s customers, products, components and suppliers comprise a tiny 5% or less of sales and profits. If you prune some of the lower 50% you will find a comparatively small
drop in sales and profits, but a large reduction in complexity and cost. Perhaps to “get your feet wet”, you could start by actually doing a 50/5 on one element of your business to see if this theory of 80/20 is likely to work. Ideally, the first pass through would be a 50/5 analysis of each of your departments or products to identify where the most impact can be found and then apply 50/5 to that area.
Once you satisfy yourself that this fairly cautious approach works you will optimise much faster if you drop the 50/5 and go to the 80/20.
If we can pass on nothing else to you in 12Faces, we would like to pass on the enormous impact the 80/20 Rule can have on your business and your life.
We encourage you to always apply 80/20 thinking to business and life situations as there is a great deal (you might not be surprised to hear 80%) that you can prune away without making too much negative impact.
Wikipedia: Pareto Principal
You Tube: several videos
Books: see on Amazon for affordable eBooks readable on Kindle. Highly recommended reading. Koch is the guru on this subject.
- The 80/20 Principle (Koch, 1997)
- The 80/20 Individual (Koch, 2003)
- 80/20 Sales and Marketing: The Definitive Guide to Working Less and Making More (Perry Marshall)