This shows how you can use a technique known as the 80/20 rule to analyse your business’ sales and profits from customers, products and services and channel to market. This information helps you to make decisions about allocating scarce business resources to achieve the best available returns and deciding how the business should grow.
The ‘80/20 Rule’ is a simple way of looking at your sales & profit figures and identifying the largest source of contribution.
Important things to know:
You may have come across the Pareto principle on which this technique is based. Very simply, it says that 80% of the outcomes will come from about 20% of your effort. It can be applied to many aspects of your business such as profits & sales.
For example:
• 80% of your profits may come from just 20% of your customers
• 80% of your sales may come from just 20% of your products & services
This simple rule has little scientific basis but invites you to analyse how productive your marketing effort is. It often leads to some interesting and useful insights into how you operate now and where you should focus your efforts in the future.
The 80% & 20% are not magical figures that work out exactly in all the situations, nor do they need to add up to 100%. Ratios such as 80/35, 80/25 or even 80/10 may equally apply, although you will be surprised to find just how close to 80/20 the relationship often is. The principle is that, in each case, we are seeking to find the source of the majority of whatever activity is being measured.
There are two obvious conclusions from this relationship.
• A small proportion of your efforts provide most of the result
• A large proportion of your efforts provide a relatively small result
You may be able to think of personal situations where you have seen this rule apply, whether it is how you spend your leisure time, your relationship with your partner, or the time you spend with your children.
A word on the limitations of the 80/20 rule, if you use historical data, this may not provide an accurate or realistic indication of the future sales or profit potential from customers, products and services or distribution channels. You need to take a view on how representative the data used is. Using data from more than one period can be more representative
How do you apply this to your business to achieve a better understanding of your marketing activities?
Sales per customer
Profitability of customer accounts
Sales of products or services
Margins of products and services
Sales and margins per channel to market (direct sale force, catalogue sales, web sales, etc)
Here are the steps to follow to analyse any of these activities:
1. Calculate the values (sale or profit) contributed by each of these activities (customers, products/services or channels) over a given period and add to a give a total. The period of analysis may be a year, but could equally to be quarter or even a month. What is important is that the customer activity in this period is representative of the norm, e.g. it is not biased by seasonal fluctuations in ordering patterns.
2. Arrange the values for each activity in descending order.
3. Calculate the value of each activity as a percentage of the total for the period.
4. Calculate the cumulative percentage in descending order.
5. Find the row in your data where the cumulative percentage is approximately 80%. Sometimes you may only be able to get 70% or 85% rather than 80% but this is not that important. Then look across to see what proportion of the activities account for the 80%. For example, if 5 out of 24 customers account for 80% of sales, 5/24=21%. The ratio in this case is 80/21:80% of sales come from 21% of customers
6. If possible, compare this information with results from the periods (say a previous year) or with an average for the industry. You should be able to obtain statistics for your industry from a trade association or market research companies like Mintel and Keynote
7. Analyse and interpret your result
• What distinguishes the high contributor from the low contributor?
• What do the results tell you about groups that your customers might fall into?
• What can you do to find more high contributors?
• What can you do to convert low contributors to high contributors?
There is no fixed process or method for using the Pareto theory.
Here are some examples of different ways to use it. There are very many more.
1. Sales/Selling example
Sales-people and selling organizations usually approach potential customers with different offerings. These offerings probably have different rates of success. But typically sellers do not understand these variances, and may use the different offerings in an arbitrary or random or instinctive way, when Pareto theory suggests that the use of these offerings can be optimized according to which offering produces the best results.
Likelihood: 80% of your new customers result from 20% of your offerings. (It may not be exactly 80-20; it might be 70-20, or 90-15, or a similar big-small ratio.)
Therefore, sellers will improve their results if they:
• Identify which offering(s) produces most new customers, and
• Then use the identified most-effective offerings more often (and use the less-effective offerings less often, or not at all).
Of course to do the necessary analysis the seller must record the offering which each new customer responded to (which sellers should arguably be doing anyway).
2. Major accounts selling example
Most selling organizations have a few large customers which represent a disproportionately large percentage of total sales.
Likelihood: 80% of your sales revenues probably come from 20% of your customers. (Often this is even more of an extreme ratio, like 90-10 or 90-5.)
It is important to understand this for several reasons:
• The more extreme the ratio, then the more at risk the overall business is. Where such a situation exists it is important to realise this – so as to protect the major customer(s), and to work towards altering the ratio by gaining new customers, so that the business dependence on one or a very few customers is reduced. (The expression “having all your eggs in one basket” refers to the risk of dropping that one vital basket and losing all your eggs – which in this case alludes to losing a very big major customer which represents a vast amount of business and jeopardizing the entire organization.)
• Every business needs to take extra special care of its major customers, especially when the ‘Pareto ratio’ is extreme and organizational viability and survival rely on just one or very few large customers.
3. Streamlining, downsizing, rationalizing, decluttering anything – reducing range, commitments, materials, ‘stuff’, etc
Most organizations and personal lives contain a far greater range of activities, possessions, products, services, suppliers, etc., than is necessary for actual effectiveness, viability, comfort, etc.
Organizations and people tend to expand activities, materials, and stuff of all sorts, over time, and all of this ‘stuff’ and obligations become expensive and cumbersome to keep, especially where there are related costs of maintenance, registrations, training, monitoring, administrating, etc. The same applies in personal lives.
The likelihood is that 80% of organizational viability/profit/effectiveness, etc., is derived from just 20% of each departmental range (product range, stock, services, etc.)
And the same probably applies in many people’s personal lives.
Analysing these distribution ratios is the first step to streamlining, downsizing, rationalizing, decluttering, etc.
Often the findings of even a quick approximate analysis of one aspect of obligations or holdings (for example stock, suppliers, possessions, etc), will immediately reveal remarkable opportunities to dramatically reduce range/obligations/holdings, with hardly any negative effects, but with massive positive benefits (for example cost-savings, space saving, and greatly decreased related obligations).
In business organizations there are commonly huge cost-savings to be achieved by rationalizing product ranges according to Pareto theory.
And in personal life there are usually vast space-savings to be made from using the same Pareto principles to declutter wardrobes, shoe-racks, bookshelves, kitchen cupboards, etc.
4. General situations of excess which need reducing, or where increased focus is necessary
Pareto theory applies logic to increase effectiveness/efficiency for any situation where there is too much of anything – in business, organizations, work, personal life and anything else.
Often in such situations nothing changes – the situation is allowed to persist due to inertia (see Nudge theory) and because the apparent size of the task is daunting, so people don’t know where or how to begin.
Pareto theory offers a quick easy way to see clearly what must be retained, and what is unnecessary.
So when confronted with any situation requiring rationalization, streamlining, greater focus, etc., use these steps:
• Identify the 20% that is vital (and which probably enables at least 80% of productivity, performance, effectiveness, etc).
• This is your starting point. Retain this 20%, and nothing else, unless it serves a crucial purpose.
• Test effectiveness and implications of the reduced range/holding.
• Refer to aspects of change management and project management as appropriate.
Note that 20% is a guide. The actual percentage which represents optimal effectiveness/necessity depends on the situation, and on other considerations, which must be factored into the thinking.
And additionally in organizational Pareto-based change:
• Ensure proper consultation happens.
• Communicate and explain clearly to all affected.
• Devise/agree a transitionary stage to enable a safe change, for example consider forms of storage or archiving of the ‘unnecessary’ items to be discarded or discontinued, etc., just in case they are needed for emergencies.
• Ensure adequate warning and leeway is offered so that people affected by the change can make alternative arrangements.
• Offer and explain alternatives for options no longer available.
Author: Hemant Dharnidharka
www.theonlineca.com