The 80/20 or Pareto principle is a long-standing business strategy that a lot of companies are applying right now to increase profit margin. It boils down to a simple statement which can be adapted to your business model: Companies should focus on the 20% of inputs that create the majority (80%) of their outputs.
80/20 SEGMENTATION TYPES
To help ensure attention to your 20%, one 80/20 consulting firm, Strategex, suggests segmenting customers and products by revenue:
- Identify "A" customers (those that represent 80% of revenue) and "B" customers.
- Identify "A" products (those that represent 80% of revenue) and "B" products.
Focus your efforts at over-serving your “A” customers and shift your time and energy away from the small and costly “B” customers that simply drain your profits. You will wind up with fewer, better customers and a good profile for what new “A” customers look like as you grow.
Your biggest revenue drivers may not be contributing the most to your bottom line, depending on their manufacturing and production needs. Similar to segmenting based on revenue, you need to pull a report of your customers and their contribution to your profit margins and determine your "A" customers and "B" customers. Adjust your sales focus to fit this newfound data and monitor your results each quarter to measure the success.
Applying the Pareto Principal through the lens of labor means the following: 20% of your labor is contributing to 80% of your success, and your goal is to improve the other 80% of employee labor to be as effective as the first twenty. 80/20 labor is a more inward-looking take on the rule than the previous two. It requires improving training, internal communication, and/or hiring to boost the efficiency of your labor.
Focusing on equipment use in the 80/20 principle is a similar inward-looking process to labor. The principle gives us two ways of looking at this: 20% of your equipment contributes to 80% of the value add to your output, or 20% of your machining is contributing to 80% of scrapped material. However, keep in mind that when you look at this, it's important to:
- Pull a report of your waste and machining usage
- Examine the data
- Focus weeding out the bad performers, or bringing up to par
- Check in periodically to monitor your results
There are many ways to apply this to your firm to guide you down a path of success and growth. For example, you might consider conforming the Pareto Principle to:
- Customer Potential
- Manufacturing Processes
- Referral / influence
- Fit with core capabilities
The Pareto Principle has stood the test of time. Books like The 80/20 Principle by Richard Koch made the best seller list, focusing the common Pareto Principle on highest margin work to create competitive advantage.
Especially in periods of high growth, it's easy to lose track of where your margin comes from. Sometimes complexity is just noise that distracts from what’s most important. By 80/20 rule, businesses can reduce complexity and prioritize their efforts for greatest impact. Across industries, companies have used the 80/20 strategy to better their businesses, for example:
- Illinois Tool Works grew from $300M to $18B by applying the 80/20 business model
- Microsoft found that 20% of its bugs caused 80% of its errors; in fact, just 1% of bugs caused half of all errors. Applying the 80/20 principle helped them to prioritize tasks and improve their product and reputation.
CHANGE IS HARD
Yes, you will have to say no. You may “fire" customers, increase prices on B products, cut product lines. Saying no is difficult, but employees will appreciate your focus, commitment to key customers, and reduced busy work. Just as important, customers will appreciate your honesty and help if you say no and refer them to a better fit company. Saying no in this way can add value and build credibility.
Many of our customers have made pursuing an 80/20 strategy a priority. The ramifications will be different for each. For one company, it means separating manufacturing lines and equipment for OEM and standard optics. For another, it means splitting industries by channel, not just geography; while they'll focus their direct sales on academic, they'll use their distributors and e-commerce for industrial sales, which require less expertise and post-sale service and offer less account potential.
For you, pursuing the 80/20 strategy may mean:
- Standardizing technology platforms
- Rethinking product families
- Retiring or sunsetting products
- Packaging service offerings
- Narrowing your target audience
- Crystallizing your brand
- Changing your thinking of competitors to partners
- Tracking new metrics or KPIs
We have worked with these and other companies to identify, profile, and understand their sweet spot – "A" customers buying "A" products. The positioning process and marketing assessment help them attract more "A"-level customers and eliminate activities that blur the lines of the brand.
Market positioning is key to implementing the 80/20 strategy. It involves customer segmentation and data analytics, as well as learning what separates you in the minds of your "A" customers to find your sweet spot.