I came across this useful summary of a brilliant business book which I read some time ago on the 80/20 Principle or Pareto Principle named after the Italian economist Vilfredo Pareto who first noticed the effect.
If you apply it to your business it can really transform how you operate and provide real tangible financial rewards. And very quickly.
So it is worth it to spend a few minutes to read and digest what follows.
We can all talk about it in general terms but we should consider using it immediately as a true guiding principle to benefit ourselves primarily.
In his business classic the 80/20 Principle: The Secret of Achieving More with Less, Richard Koch does just that. He tells us by using the principle as a guiding light we can become more successful. If we can spot the few cases where the results relative to effort are so much greater than usual, we can become so much more efficient in whatever task we want to accomplish.
The 80/20 Overture
So what is the 80/20 Principle? In simple terms the 80/20 Principle states that a minority of inputs or effort usually leads to the majority of the results, outputs or rewards. It doesn’t always fall into the 80/20 ratio, it could be 90/10, 75/25 or 85/15 but in general cause and effect are significantly imbalanced.
Koch tells us that at the heart of the application of the principle is a process of substitution. If we can replace the 80% less effective activities and replace them with more of the 20% effective activities then productivity can increase. If we can focus more of our efforts on the 20% of our best customers and less on the 80% high maintenance customers, we can in turn increase our profitability.
Why continue to make the 80 per cent of products that only generate 20 per cent of profits? We rarely ask these questions, perhaps because to answer them would mean very radical action: to stop doing four-fifths of what we are doing is not a trivial change.
Chaos and Tipping
Koch suggests that there is a correlation between Chaos Theory and Pareto – the common thread being imbalance. Both theories say that the world is not linear; cause and effect are rarely linked in an equal way. Some forces are always more forceful than others and will try to grab more than their fair share of resources.
The 80/20 Principle aligns to the feedback loops identified by chaos theory, whereby small initial influences can become greatly multiplied and produce highly unexpected results which can only be explained in retrospect.
Koch suggests there are always a few forces that have an influence way beyond their numbers and these are the forces that we must identify and watch. If they are forces for good we should multiply them. If they are forces we don’t like, we need to think very carefully about how to neutralise them.
Also related to the idea of feedback loops is the concept of the tipping point. Koch gives an epidemic example. The tipping point is the point at which a low-level flu outbreak can turn into a public-health crisis because of the number of people who are infected and can therefore infect others. The principle also applies in reverse – where small changes, like bringing new infections down to thirty thousand from forty thousand, can have huge effects. That’s Pareto in practice.
On the 80/20 Highway
Koch gives us two concepts to consider: 80/20 Analysis and 80/20 Thinking
80/20 Analysis examines the relationship between two sets of comparable data. One set of data is always a major sample of people or objects, usually a large number that can be turned into a percentage. The other set of data relates to some interesting characteristic of the people or objects that can be measured and also turned into a percentage.
What is 80/20 Analysis used for?
In practice to change the relationship or to make better use of it. That’s where the advantage lies! One use is to concentrate on the key causes of the relationship, the 20 per cent of inputs that lead to 80 per cent of the outputs. Another way is to do something about the ‘underperforming’ 80 per cent of inputs that contribute only 20 per cent of the output.
Focus on the good and make better and/or focus on the weak and make weaker.
Koch gives a useful example. In US shopping malls it has been found that women account for the greater percentage of the dollar value of all purchases. Simply put women spend more. One way to increase the percentage of sales of men might be to build stores specifically designed for them.
Koch gives us further advice on how we should approach 80/20 Analysis. He suggests when we use the 80/20 Principle, we should be selective and go against normal thinking. We should not fall into the trap that the variable that everyone else is looking at is what really matters. This is linear thinking. The most valuable insight from 80/20 Analysis will always come from examining non-linear relationships that others are overlooking (or not aware of!).
Koch states if we want the 80/20 Principle to be a guide in our daily lives, we need something less analytical and more instantly available than 80/20 Analysis. We need 80/20 Thinking.
He suggests, 80/20 Thinking requires us to spot the few really important things that are happening and ignore the mass of unimportant things. It teaches us to see the wood for the trees.
To engage in 80/20 Thinking, we need to constantly seek out the 20 per cent. We will not always know the answers but we need to embark on some creative thinking to identify the few vital few inputs or causes. 80/20 Thinking therefore is a second phase to 80/20 Analysis.
When we’ve identified an 80/20 cause we need to decide if it is beneficial to our objectives – will it help us get better – and if so how can we increase its impact. On the other hand if it’s not beneficial to our objectives we need to identify how we can frustrate its development.
Koch suggests we focus – not to look at being good at everything but to be exceptional at a few. Like the principle itself, we should concentrate on a few areas which can produce greater benefits from outperforming others.
80/20 Business Application
Koch gives us a few immediate pointers on how to apply the 80/20 Principle in our businesses.
Think small. Don’t plan to the nth degree. The return on investment usually follows the 80/20 rule: 80 per cent of the benefits will be found in the simplest 20 per cent of the system. This is especially true for software, where 80 per cent of a product’s uses take advantage of only 20 per cent of its capabilities. That means that most of us pay for what we don’t want or need.
Segment and Focus. In any market, some suppliers will be much better than others at satisfying customer needs. Over time, 80 per cent of the market will tend to be supplied by this 20 per cent or fewer of the suppliers, who will normally also be more profitable. To get a share we need to divide the market up into segments and identify which segments are in the 20 per cent. If we are in too many segments then get out of those in the 80% or analyse profitability to focus only on those where the 80/20 Principle applies.
Make a Killing. If you can identify where your firm is getting back more than it is putting in, you can up the stakes and make a killing. Similarly, if you can work out where your firm is getting back much less than it is investing, you can cut your losses. In this context, the ‘where’ can be anything. It can be a product, a market, a customer or type of customer, a technology, a channel of distribution, a department or division, a country, a type of transaction or an employee, type of employee or team.
Koch claims unless we have used the 80/20 Principle to redirect our strategy, the strategy is badly flawed. We don’t have an accurate picture and almost inevitably we are doing too many things for too many people.
He says we need to identify which parts of the business are profitable, which are just breaking even and which are disasters. To do this we need to conduct an 80/20 Analysis of profits by different categories of business: for example by product or product group/type or by customer or customer group.
He gives us a series of challenging investigations. He asks:
80 per cent of the profits made in any industry are made by 20 per cent of firms. If you aren’t one of these, what are they doing right that you’re not?
80 per cent of the benefit from any product or service can be provided at 20 per cent of the cost. Many consumers would buy a stripped-down, very cheap product. Is anyone providing it in your industry?
80 per cent of any industry’s profits come from 20 per cent of its customers. Do you have a disproportionate share of these? If not, what would you need to do to get it?
When we’ve done the 80/20 Analysis of the above, Koch says only then can we set our 80/20 Strategy focuses on the 80/20 Principle.
Here is Koch’s hypothesis. Simple is beautiful but business people love complexity. No sooner is a simple business successful than its managers pour vast amounts of energy into scaling it up, in turn making it much more complicated. Yet additional scale is rarely just more of the same. Even if the customer is the same, the extra volume usually comes from adapting an existing product, providing a new product or adding more service.
When business is simple, the chances are that it is closer to the customer. There is less management in the way. Customers can be listened to, feel that they are important and are willing to pay a lot more for this.
So how can we scale at the 80/20 levels? Koch suggests the following:
We should let go of the less profitable customers and products, cut off most support and sales effort, raise prices and allow sales to decline, bring simplicity and profitability back. Why? Simply because difficult customers demand more resources.
Be customer centred for the few right customers. Successful marketing is all about a focus on the relatively small number of customers who are the most active in consuming your product or service. Focusing on 20 per cent of your customers is a great deal easier than focusing on 100 per cent of them. Being customer centred on all of your customers is almost impossible.
Core Customer Lock In
Koch gives us four steps to lock in our core customers:
Step 1: Identify who the 20 per cent are!
Step 2: Provide exceptional service.
Step 3: Target new products and services solely at them.
Step 4: Keep them forever!
80/20 Decision making
Koch suggests we can make critical decisions in alignment with the 80/20 Principle. We are going to apply it pervasively so decision making is no exception.
Rule one says that not all decisions are very important. Using the 80/20 split we should avoid agonizing over the unimportant decisions and above all don’t conduct expensive and time-consuming analysis. If its unimportant and has a 51 per cent probability of success – go for it!
Rule two says the most important decisions are often those made by default, because the chance to influence has passed. When this happens, no amount of data gathering and analysis will help you realise the problem or opportunity. What you need are intuition and insight: to ask the right questions rather than getting the right answers to the wrong questions.
Rule three is straight off the 80/20 bat. For a critical decision, gather 80 per cent of the data and perform 80 per cent of the relevant analyses in the first 20 per cent of the time available, then make an assertive decision with 100 per cent confidence. Generally you won’t be wrong!
Rule four? Simply, if what you have decided isn’t working, change your mind early rather than late.
And finally rule five when something is working well, double and redouble your effort. You may not know why it’s working so well, but push as hard as you can while the force is with you.
You can find more information on our summary of the 80/20 Principle here http://parfreymurphy.ie/business-growth-are-you-using-the-8020-principle/
Or better still, go buy the book and apply its insights! A great read.