And where should you use it?

No doubt you have heard of the 80-20 rule, sometimes known as Pareto’s Law.  And you will have some idea of what it means.  But do you really?  And do you understand how to use it, and where you can use it, and how to do so effectively?

You have probably know of it in relation to sales; 80% of your sales come from 20% of your products.  It is also suggested that 80% of sales come from 20% of your customers.  Both can be true, which I’ll explore in a minute. 

If you are looking at improving your profitability and cash flow then the 80/20 rule is also a very useful tool in a number of other areas which I’ll look at in this and the next blog.

But first, where did the concept come from and why is it also known as Pareto’s Law?  Pareto was an Italian economist who observed in 1906 that 80% of the land in Italy was owned by 20% of the population.  He later investigated other countries and found, to his surprise, that the same principle applied.

It was an American consultant, Joseph Juran who, many years later, named the principle Pareto’s Law.  He also referred to it as "the vital few and the trivial many".  He was one of the key people who developed quality management and continuous improvement.  In later years, Juran preferred "the vital few and the useful many" to signal the remaining 80% of the causes should not be totally ignored.  And I agree with that.

Let’s get to the meat of this; how to use 80/20 practically in your business.  The first thing to understand that of course the ratio is not going to be exactly 80/20.  The vital few could be 67/33 or whatever.  What you are looking for is the ‘vital few’. 

Product Sales & Profits

Do you know which of your products, or product groups, produce the majority of your sales?  You should.  The figures should be in your Profit & Loss Statement by major groups, and further drilling down into them should give you more detail.

If your accounts don’t show sales by product group then have your bookkeeper or accountant redo your Chart of Accounts to give you this information.

Here is a fictitious example of a car parts business:

So 70% of sales come from two product lines.  That is useful to know.

But what about profitability?  Now this is even more useful to know, but surprisingly I find many businesses I have assisted improve their profitability and cash flow don’t have this basic information.


80/20 now gives us a different picture.  Again, two product groups dominate Gross Profits with 80% of GP, but one is different. 

Using the “useful few” is helping us make some useful decisions, and they are likely not to be the same if we hadn’t used the tool on GP as well as sales.  Drilling down using the 80/20 tool helps.

What about Customers?

Might it be useful to apply the 80/20 tool to our customers?  After all, we sell products and services, but customers buy them.  Their decision, not ours.

Where do you get the information?  From your accounts.  All accounting packages will produce a list of customers and sales to them. 

But I’ll bet very few of you group those into customer groups or market segments on a monthly basis, something that has always proved passingly strange to me.

Let’s look what you might learn, staying with our hypothetical example:

 

So 64% of sales come from just two market segments, and they couldn’t be more different; mechanics (a small business), and individuals.  They make decisions for different reasons.

Now go back and look at your profitability table.  Where do the useful few profits come from?  They come from Accessories and Audio.  And who buys Accessories and Audio – Individuals do! 

So what does this mean for your marketing, future cash flow and profitability?

Applying the 80/20 tool and then applying it again can reveal very useful information that can make a significant difference to your profitability.

In your next blog I’ll look at where else you might apply this most useful tool to improve cash flow and profitability.

To your profitability.


© Copyright 2014 Adam Gordon, The Profits Leak Detective

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