The Pareto Principle, or 80/20 rule, describes the phenomena that 80% of results come from 20% of causes. It was named after economist Vilfredo Pareto who noticed that the top 20% of the population in Italy controlled about 80% of the land. This principle extends to many areas including business, for example:
- 80% of a firm’s revenue comes from about 20% of its customers;
- 80% of purchases from 20% of its inventory; and
- 80% of sales are made by roughly 20% of the sales staff.
When applied to business management, this principle can direct prioritisation and focus – the trick is to identify and target the right 20%. Here are six examples of how business owners can apply the 80/20 rule to improve business performance significantly.
1. Time Management
The Pareto Principle applied to time management says that people spend 20% of their time doing activities that result in 80% of their output. Indeed, studies have shown that the average office worker works effectively only a mere 2 hours and 53 minutes in an 8 hour day. Identifying that 20% of activities, and ruthlessly triaging and cutting out activities that add little value in the long term, significantly leverages effectiveness. It also results in better concentration and a mindset to pursue important and value-adding activities, rather than being bogged down by trivial or unnecessary tasks.
Perfectionism is a common time-sink. In drafting a report, one might take two hours to create the content and design, but spend eight hours to tweak the draft and perhaps do extra research. Instead, it would be better to send the draft to someone for feedback once it’s about 80% done. They may not only believe that it needs much less perfecting than you’d expect – which saves time and effort – but getting feedback early in the process can help produce a better quality product. Often, practicality is more important than perfection.
Many projects and decisions also suffer from ‘analysis paralysis’ – the phenomena of over-analysing a problem or situation until one is stuck in the planning stage for a long time without actually coming to a decision or starting the project. For example, in launching a new product to customers, market a minimum viable product as soon as you are 80% ready. Again, it is more important to receive constructive feedback from real customers for a real product early so that you can iterate the design than have no feedback and perfect a product that no one might ever want to buy.
2. Segment the Problem
Segmentation shows the unbalanced distribution of the Pareto Principle in play and often gives insight into how to position the business for greater profitability. This involves recognising how problems, systems or processes can be broken down into its components, for example:
- Splitting a company into business units;
- Grouping products by product lines; and
- Categorising revenue by revenue streams.
A business can then see how each segment performs individually and identify the all-important top 20%. This is particularly useful as averages cannot tell us much. For example, a business might have an average product value of $500. However, their metropolitan stores might have sales of $200 per customer while their suburban stores generate $800 per customer, suggesting the business should investigate why suburban stores are performing better. Without first breaking down the stores by location, the insight into profitability would have been lost. Segmentation provides visibility into averages and the underlying processes, leading to better-informed decisions.
3. Revenue Sources
There are many ways a business might acquire customers, such as through their website (paid and organic), word of mouth, referrals, TV and radio advertisements, or outbound channels. Not all channels are equally profitable – roughly 20% of them will generate 80% of the revenue. Look at the cost per acquisition by revenue source, as well as the lifetime value per customer, and consider whether to reallocate resources to the highest-profit sources.
On the other hand, diversifying revenue sources is a good thing, as it spreads out the risk that a source might fail. For example, if a business’ website was down for a week but that was its only revenue source, it would have no means of generating revenue. Hence, it might be worth keeping even low-margin revenue sources and finding ways to optimise them.
4. Cost Savings
The Pareto Principle in cutting costs is about not being “penny wise, pound foolish.” 80% of costs come from big ticket items which make up only 20% of assets. While small costs do add up, it is far better to focus on getting a good deal on rent and carefully considering the assets on your balance sheet, than it is to worry about the price of a lunch you are treating a customer or employee.
5. Product Offering
A business may offer a broad range of products. However, the top 20% of products account for 80% of the revenue, and while a majority of the products only account for a small part. As a business has finite resources, it may be strategic to discontinue certain product lines to reallocate resources toward the top performing products. Look at the margins for each product, the percentage of revenue they contribute to, and how scalable or duplicable they are. Consider discontinuing the lowest-margin products and scaling the highest-margin products. Reducing and optimising the product range also simplifies, reduces costs and improves efficiency within the supply chain.
6. Combining Factors to Sharpen Focus
Business consultant and entrepreneur Perry Marshall writes in his book, ‘80/20 Sales & Marketing’ of the power of combining multiple factors.
If 20% of customers generate 80% of the revenue, and independently, 20% of products generate 80% of the revenue, then 64% of the revenue (80% of 80%) came from the 20% of products the top 20% of customers bought. This means that focusing on the overlap between top customers and top products (20% x 20% = 4%) results in leveraging 64% of the revenue. If you have 1,000 customers, this means targeting 40 of them – manageable enough to be done on an individual basis, and yet with magnified effects.
Combining multiple factors with the 80/20 rule multiplies their effect. For example, a common framework used in database marketing is the RFM matrix, which considers the recency, frequency of purchases and monetary spend of each customer to assess customer value. Imagine these three factors as axes of a 3D matrix, with the most recent, frequent and high-value customers in one corner. These are your best customers to target.
Of your best customers, some will be happy to pay for more expensive products than you offer. That is, you will be able to provide more value to some particular clients and generate more revenue from them. For example, if 100 of your customers are willing to pay for a $100 product, and you offer these customers a product worth say $300, a subset of them will be willing pay for this new product. This is a subtle application of the 80/20 rule: the distribution of customers with the need or willingness to pay more will result in revenue following the Pareto distribution. By recognising that some customers have a greater capacity to spend and offering appropriate products, business owners can realise this untapped capacity.
A Word of Caution
While applying the Pareto Principle can point out areas to focus on, taking it to the extreme by neglecting or completely abandoning the bottom 80% is often counter-productive. Depending on the situation, the bottom 80% might be necessary for all kinds of strategic reasons: diversifying risk, reducing costs in other areas or maintaining company culture.
Another example of when not to focus solely on the top 20% is with new strategies, ventures or experiments. Establishing a new revenue source or offering a new product might be unprofitable or very marginally profitable, and would be in the bottom 80%. However, it is important to try new ideas to see which ones work and which don’t, and investing into these activities by raising funds through other more profitable sources of strategic value, rather than merely economic.
Applying the Pareto Principle well leads to greater effectiveness as it leverages your time and resources to the factors that lead to the biggest results. The first step is to identify the most valuable activities and resources. Businesses can do this by breaking down a problem by segmenting it and observing how the different segments perform. This technique can be applied to revenue streams, cost base, time spent and product lines and distribution channels for better resource allocation. At the same time, while giving lesser priority to the resources or activities in the bottom 80%, consider their strategic benefits as well. By taking a step back from any situation and applying the Pareto Principle, you will be able to realise much potential for efficiency and profitability.
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