80/20

What is it?

80/20 is a management principle to encourage you to focus on what is important in any situation.

It is a mantra to invoke whenver you find yourself sweating the small stuff. Most companies are complex, having sprawled organically way beyond their core. Don’t be fooled by this complexity – the core where they make money is much smaller.

Profit pool

When is it useful?

Every business needs a Spring clean on a regular basis. New customers and products get added on an incremental basis, and internal politics makes it hard to give them a clean death. So over time, the law of entropy dilutes the focus from the profitable core with lots of unprofitable baggage.

Making things worse, accounting systems are terrible at accounting for the cost of complexity, making small customers and product lines appear profitable when they are really draining profit from your company.

Every business should conduct a regular cull, lopping off the  bottom 25% of products. Any incremental profits shown by these are illusions of the accounting system – like a rose bush, the company will grow back more healthy after being pruned.

Whenever you are analysing a company, forget the 20 and focus oall your analysis on the 80 without distraction from the “hobbies”.

An Example?

The Apple example is of the 75/8 rule, even more extreme than 80/20.

These are huge generalisations, but test them for your own business:

  • 80% of revenues come from under 20% of customers
  • 80% of profit come from 20% of products (or SKUs)
  • 80% of value creation comes from 20% of business units
  • 80% of the value you personally contribute comes from activities that take 20% of your time

How do you do the analysis?

Your accounting system should be able to crank out the 80/20 on customers and products – but remember, unless it is an unusually sophisticated Activity Based Costing version, it will hugely understate the real 80/20 situation. In fact, it is not unusual to find that your core makes over 100% of your profit – it subsidises the parts of the business where you are less competitive.

A high impact way to communicate the 80/20 rule is to draw cumulative profit on the vertical axis against Number of SKUs/Customers along the horizontal, showing the long tail of customers and products most companies collect.

I want to know more

 

How can you adapt this concept?

The 80/20 principle travels well – there is no element of your life it cannot be applied to.

 

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