Playing to your strengths in business is where your profits lie—but how do you focus on those strengths that will make you money? It’s a question that has baffled businesses for hundreds of years until economist and sociologist Vilfredo Pareto spotted a recurring pattern in his studies in 1906. From his observations he developed a potent business formula that empowers managers to improve the fortunes of their businesses.
Like all good rules, it’s short, sharp to the point. It states that 80% of our results come from 20% of our activity. That’s it! Applying this formula to your business will help you save time, effort, and resources—plus make you money as well.
The Pareto Principle
Italian aristocrat Pareto was born in 1848. He developed the principle to describe the unequal distribution of wealth in his country. He observed that 80% of the wealth was generated by 20% of the population. Later, he noted that the ratio applied to other activities, like gardening. He calculated that 80% of his peas were from 20% of his peapods. Over time, many others took this concept and could apply the rule to their sectors.
Eventually, the discovery was known as the Pareto Principle or the 80/20 rule. Other examples are:
* In horse racing, 20% of the horses win 80% of the races.
* We wear 20% of our clothes 80% of the time.
* 80% of crime is caused by 20% of the criminal population, and so on.
The 80/20 rule means that in any sector, a few—the 20%—are absolutely vital, and the many—the 80%—are less so.
You can observe the Pareto Principle in your own business. You will probably note that:
* 80% of your sales come from 20% of your customers.
* 80% of profits come from 20% of your products.
* 80% of the profits made in your industry come from 20% of the companies—and hey, if you’re not one of those companies, why not?
* 80% of the complaints come from 20% of your customers.
The figures are not exactly 80/20 in every case. Some are 75/25 or 83/17. It’s not an exact percentage, more a rule-of-thumb or a benchmark. The value of the Pareto Principle to your business is identifying those activities that are making you the most money, and just as importantly, those that make the least. Then you must act to weed out the underperforming activities and concentrate all your passion, energy, and resources on the top 20%.
Many businesses fail because they don’t spot or fail to deal with underperformance. You may think you already have a full understanding of the performance levels of all the parts of your business, but a clear picture won’t emerge until you apply the 80/20 rule.
The key for your business is to make more money out of key customers. In other words, generating the most profit from applying the least amount of resources. Take a long, hard, and objective look at what you do. Where you probe depends on the nature of your business, but generally you will examine performances of products, markets, types of transaction, and employees.
These activities and people that give you the most should be nurtured, loved, rewarded, and frequently tended. Say goodbye to everything else.
Apply the 80/20 rule to your business
Apply the Pareto Principle to any part of your business, and it will constantly remind you to stay focused on the 20% that matters. Here is how you could apply the principle to help your company attain peak performance:
Who’s the highest performing salesperson in your organization and could they be helped to achieve even better results?
Apply the Pareto Principle sensibly and encourage your other sales people to adopt the best performer’s methods. Focus your attention on the 20% of products and services that are generating the most sales and profits.
Compile a list of customers and how much revenue each one has generated for you. Then work out the cost of overheads and resources that are consumed to support each customer. This involves some pretty serious and challenging cost accounting to calculate each client’s share of administration and support services. Subtract this amount from the gross revenue total for each customer. You can now rank your customers to find out which ones are in the profitable top 20%.
This should lead you to make some strategic decisions about increasing services to the most valuable clients to get them to spend more and about reducing the amount of time and effort spent with customers that are producing little revenue.
Apply the 80/20 rule to the markets that you serve. If you sell multiple products to different markets, evaluate and rank them with the same cost accounting methods you applied to customers.
The Pareto Principle in Action
Here’s how the Pareto Principle boosted the business of a secondhand music store. The proprietor buys and sells records in multiple genres covering several decades of music. The business lacks focus and direction and much of the inventory remains unsold.
It’s crying out for applying the 80/20 rule. The shelves are groaning under the weight of decades of unsold music.
To get the business humming, the owner must work out which records sell the best and which sit on the shelves wasting space and gathering dust. This takes four simple steps.
1. Divide the records into categories.
2. Compare the inventory of each category against the sales in the same category.
3. Focus on the most profitable 20% of sales.
4. Discard the rest.
This way, the record shop concentrates on matching products to demand and frees up shelf space to offer more of those products to customers.
Kick out losers
The key to making the most of the Pareto Principle is to know your strengths, play to them, and show ruthlessness by kicking out losers. Your business will not improve if you work a little harder, put in a few more hours, or do the same things a little better. If a business is not performing well, real change comes from making strategic decisions. The Pareto Principle can help. A business has a much better chance of thriving in the marketplace when the focus is on the things that actually make a difference and cull the waste.© Copyright 2010 Ali Brown