For the next few weeks we shall be looking at some principles and ratios needed to optimize your business operations as well as some to check if the business is on track.
Today, we will look at the Pareto principle or the 80/20 rule and review its applications for your business. The Pareto principle is a rule of thumb underpinned by a cumbersome Mathematical law (power law). But you needn't understand the law to understand the principle; a cursory look at your surrounding is enough to prove its merits. The principle links cause and effect and is used in determining how to optimally allocate your ‘scarce’ resources. In layman’s terms, Pareto principle states that if 100 factors can cause 100 effects, about 20 of the factors will likely cause 80 of the effects. If I've succeeded in confusing you, let me un-confuse you with the following illustrations.
If you are a kindergarten teacher unlucky to have a perpetually noisy class, 80% of the noise is the handiwork of 20% of your pupils. If you are like my friend, who collects shoes like bees do pollen grains, you’ll wear 20% of the shoes on 80% of your outings. If you are a salary earner, always complaining that your take home cannot take you home, 80% of your monthly income is consumed by 20% of your expenses. And on and on it goes. Actually, the man credited with the principle postulated it when he noticed that 80% of the land in his country was owned by 20% of the population. Can you give other examples of similar phenomena in your surroundings?
Now, how does this affect your business? Let’s start by saying that there are no limitless resources; sooner or later everything finishes or diminishes. Examples of limited business resources are your time, energy, capital, staff strength and assets. It follows therefore that you want to distribute or utilize these resources in such a way that you can get the most from them. Without being conscious of it, all humans find themselves planning how to best use their resources every day. As soon as you step out of bed, your ‘subconscious’ estimates that you have only 12 hours of daylight. Then your brain kicks in and starts shifting around the tasks for the day, scheduling what needs to be done and how it should be done; so that when the sun sets only the less pressing activities would be left undone. Sometimes we succeed at this and many times we fail, but the Pareto principle is a management tool that can help us to always succeed in the way we allocate scarce time. Now that we understand the principle and why we need it, let us apply it for your business.
Pareto says: 20% of your customer base will purchase 80% of your product or services.
As a shrewd entrepreneur, you want to find out who these 20% are and allocate your best resources to their service. They are the ones you will do well to reserve your best customer service for. If there is a long queue, you surreptitiously give them the VIP treatment without riling up the others on queue. Your smartest and most polite employees are to be assigned to them. Regarding incentives, if there are certain discounts to be enjoyed, ensure that they are targeted at them. You should also spare no effort in going all out to get their feedback; it is a top priority.
Pareto says: if you have a wide product mix, 80% of your revenue comes from 20% of your products.
The 20% products are the geese that lay the golden eggs. For instance, if you make several products in your business, say a pastry business that sells pies, sausage rolls, hors d’oeuvre, buns and cakes. 20% of these products will generate 80% of your sales. If you are in the service business, like a supermarket selling a wide range of stocks, 20% of the stock will make you 80% of the revenue. A smart business owner will ensure that the quality of these ‘cash-cows’ is maintained and if the funds available for research and development are in short supply, the R & D labs working on the 20% don’t feel the pinch. If for any reason he needs to scale down his operations, the smart business owner will quickly throw any of the 80% products over board and keep his precious gold-laying geese. Advertising and branding funds will be heavily expended on the 20% products as well.
Pareto says: 20% of your workforce are producing 80% of your crucial business operations.
Whether it is a marketing team or a strategy team, not all the members will produce the same amount of deliverables. Most will perform minimally while only a few will bring the chunk of sales or ideas, respectively. A forward-looking entrepreneur will design his compensation package to stimulate the 20% to give even more; the last thing he wants is his competition poaching them. My ex-supervisor often quips that the reward for diligent work is more work, so what he does is to assign the 20% to the time-sensitive and pivotal tasks, leaving the 80% to pick up the menial and less crucial job descriptions.
Pareto says: 80% of your expenditure is devoted to 20% of your expenses.
You will have to pay rent, wages, taxes and utilities like maintenance, electricity and water to remain in business. Oftentimes, you are too busy juggling several responsibilities to have enough time to monitor all your expenses. Knowing that four-fifths of your expenditure will be gulped by only one-fifth of your expenses, helps you to devote scarce time and attention to monitoring what’s more important. These are the items you want to check daily and thoroughly to keep from snow-balling into an unmanageable expense. When you are less busy you can then do a comprehensive review of the books. Also, if you are cash-strapped, the principle helps to easily decide where to channel your resources.
What about the 20/80 that’s left
My advice on the 80/20 has been to give it your best; never mistake it with giving it your all. Firstly, nothing says the less performing employee and product or less crucial expense or customer cannot gain more prominence tomorrow. In fact, you don’t want to be caught napping when a product that you have relegated to the background suddenly becomes the in-thing. Instead, you should be the one to take it from the back-burner to prominence. Also a 20% employee will leave someday, even if you empty your vault to change his mind. Get one or two of the 80% employees to understudy him or model on him for the day he decides to leave. What’s more, if a 20% employee knows how invaluable he is to you, he can start making unreasonable demands that you can’t meet. Before that day comes when it’s either you give him what he wants or you get stranded, let him understand that he isn't indispensable by devoting some of your resources to train the 80% employee.
Lastly, the Titanic had 16 watertight compartments to forestall flooding of the ship and its eventual sinking. Hitting the iceberg caused a gash in only 5 of them but it was all that was needed to sink the behemoth. My calculator shows that 5 out of 16 is 31.25%. If a breach in one-third of the compartments eventually countered the buoyancy of the remaining two-thirds, what do you think will happen if you drop the ball on four-fifths of your business compartments? Regardless of whether they have strong indicators or not, they are still potent enough to drag your business to the ocean-floor.