What Does The 80/20 Rule Mean For Your Business?
Recognizing the implications of the 80/20 Rule, also known as the Pareto Principle, can have a profound impact on your business and your life. But why is this? Well, if you apply it to your business or your life, you will quickly see that 20% of your inputs will yield 80% of your outputs or that 20% of your effort will deliver 80% of your results. Applying this rule to your business can stop you from wasting 80% of your time on activities and customers that only generate 20% of your income. It all sounds too simple to really work, right?
Maybe, but first consider the following imbalances, which perhaps exist in your business right now:
- 20% of products sold in a business typically account for 80% of the revenue
- 20% of the customers of a business typically generate 80% of the profit
- 80% of results typically come from 20% of the effort employed
- 80% of a market will normally be supplied by 20% of the suppliers
- 80% of the profits made in any industry are made by 20% of firms
- 80% of the value perceived by customers relates to just 20% of what an organization does
- You can eliminate 80% of the waste in your business by spending just 20% of what it would cost you to get rid of 100% of the waste
The lessons from this are really important. We tend to assume that equal effort will deliver equal results. 50% of inputs rarely equate to 50% of outputs and linear relationships between inputs and outputs rarely exist. The balance is nearly always skewed towards the 80/20 Rule.
If demanding customers take up 80% of our time and only generate 20% of our profits, do we really want them as customers or should we encourage them to do business elsewhere? I would suggest that you reduce the level of customer care to troublesome customers. Find a new way to service these customers, which reduces your costs or increases your margins to required levels. If this does not work, have the courage to say goodbye.
If 20% of our products generate 80% of our revenue, then would it be wise to shed products that are not generating an adequate financial return? The answer is clearly yes, unless there is an obvious and demonstrable portfolio effect relating to the product that would damage a customer relationship or impact profits negatively.
If 20% of our sales staff generate 80% of our sales, then would be better off recruiting new sales staff more like our high achievers and encouraging the poor performers to work for someone else? The answer here is also a clear yes, subject to observing the legal implications and HR protocols of firing poor performing employees.
Taking the 80/20 Rule as broadly reflective of how our businesses operate, how can we dispense with the 80% of business activities that generate little or no return for us? The answer is to focus on simplicity and to work to eradicate complexity in our businesses. As businesses become more complex, financial returns can fall dramatically and so we must work to implement the simplicity that can restore returns to adequate levels.
Customization is expensive and the more our customers prevail on us to deliver non-standard product variations, the more complex and expensive our business model becomes. Adding scale to the business is fine just so long as it is predicated on replication, automation, and repetition and not on customization.
Complexity comes at a high cost, which can drag down core profits and add significantly to overheads. The only exception to this is if you run a bespoke business that competes on the basis of a differentiated or customized offering. In this case, don’t make the mistake of charging commodity prices for customized solutions.
Taking this to its next logical conclusion, cutting the number of suppliers, products and customers can lead to higher profitability because of reduced complexity and due to a laser focus on the most profitable activities and customers. This is not to say that a large proportion of overheads will disappear altogether, but if you identify where your costs are out of kilter with your core business model, you are then in a position to take aggressive action to reduce them. Excessive overheads can always be eradicated once you have a mind to do so.
If possible, flatten out your management structure as part of the simplification process. Managers often thrive on complexity and the more simple you make your operation, the fewer managers and direct reports you will need to run your business effectively. This can seriously cut executive pay expenses in your business without any loss of control or execution capability.
Another tactic to be used when turning the 80/20 ratio on its head is to focus all of the energy and expertize in your business on what it excels at and to outsource all other activities. Globalization and the power of the Internet have made it easy to shift activities and functions to third party specialists around the globe. This reduces headcount and direct overhead while speeding up your delivery capabilities.
Focus your marketing effort on delivering an outstanding presentation and service on the 20% of products that deliver 80% of your revenue. Similarly, focus your marketing effort on the 20% of customers that generate 80% of your profits. De-emphasize or discontinue promoting products that generate inadequate returns.
For more information on the 80/20 Rule, I would recommend you read the book on this topic by Richard Koch, available on Amazon.