Italian economist Vilfredo Pareto (1848–1923) observed that 80 per cent of the healthy pea pods he harvested came from just 20 per cent of the pea plants in his garden. He investigated this further and discovered that 80% of the land in Italy was owned by 20% of the population. Further examination confirmed this kind of uneven distribution was widespread and commonplace, and extended across many fields.
A couple of decades after Pareto’s demise, Joseph M. Juran (1904–2008) happened upon this information and applied to his own field of work – quality. He discovered that it held true, and that 80 per cent of the problems encountered could be attributed to 20 per cent of the causes. He coined the term ‘The Pareto Principle’, also known as the 80/20 rule.
Richard Koch (1950–) was next to pick up the baton. He published The 80/20 Principle in 1997. The book took the 80/20 rule and extended it, postulating that in both business and personal life, 20 per cent of the effort produces 80 per cent of the results. The book became a business classic and a global bestseller.
‘So what?’ you might be thinking. Well, the 80/20 rule also applies to aspects of your business. For example, 20 per cent of your activities will generate 80 per cent of your results, and 20 per cent of your customers will generate 80 per cent of your revenue. This is important information! It can help you to increase both productivity and profitability.
If you had an employee who was underperforming, you would look at ways to help them improve their performance and, if that failed, to move on. This isn’t cruel or unfair, it’s necessary. Poorly performing staff cause bad feeling. You might have even heard someone grumble, ‘It doesn’t matter whether you graft or skive, you still get paid the same.’ You don’t want your grafters to become skivers, or to lose heart and leave.
The same principle can be applied to customers. You can do a quick and dirty analysis to see the truth of it – put your customers into general categories and see just how few generate the bulk of your revenue. The next step is to decide what you are going to do about it. It’s one thing to dismiss – or enable to move on – poorly performing staff, but do you ever do the same with customers? Some of these people may be costing you money!
Keen gardeners will tell you that while fertiliser will help a plant to grow, it’s also essential to cut out the dead wood, both to protect a tree from pests and potential disease, and to make room for new growth. That also applies to business, and the 80/20 rule can help you identify where the fertiliser should be applied and where the dead wood lies.
The Biggest Cheque Exercise
This is an exercise based on the application of the Pareto Principle. Here’s how it works. First, draw a table, as follows:
- In the left-hand column, list your 5 best customers (however you may define that term).
- In the middle column, headed ‘A’, enter the total revenue you generate annually from each customer, then calculate the total value of the column.
- In the right-hand column, headed ‘B’, enter the total revenue you could generate if you sold each customer your complete range of goods and services. Now calculate the total of that column.
- Compare the column A total with the column B total and ask yourself, ‘How should we change the allocation of our marketing and other resources to increase the value of column A?’
This is an approach based on building on what you’ve got, leveraging loyalty, if you like. Or applying fertiliser to encourage growth.
This next exercise takes a different approach. This one is aimed at cutting out the dead wood.
Your team will know all too well which customers may be categorised as ‘bad’. These ‘bad’ customers will tend to have certain common characteristics, including:
- They are unprofitable or marginally profitable.
- They argue about prices.
- They are slow to pay.
- They are high-risk.
- They complain – a lot.
- They are slow to respond to requests.
- They don’t refer new customers.
- They have unrealistic expectations.
- They abuse team members.
- They are rude.
Twice a year, get everyone together and ask each team member to nominate one, two or three customers for expulsion.
Once you’ve identified which customers are dead wood and need to go, you can decide on the best approach to use to cut them out of your business. You could:
- Sack them in person.
- Sack them over the phone.
- Sack them by letter or email.
If you decide to do it by letter or email – arguably the least uncomfortable method – then here’s an example of suggested wording:
And there you have it. The application of the 80/20 rule to both grow your good customers and cut out the dead wood, to make room for new growth in your business.
Still not sure?
This can be a tricky exercise to undertake, especially if you’re doing it for the first time. Business lore will tell you that the customer is always right (which they are … until they’re not) and that all customers are to be valued (and again, they are … until they’re not).
We know what a mindset change it is and how tough it can be to do, because we have gone through the same process, many times. Get in touch and I’ll be happy to share my knowledge and explain how we can help