How the 80/20 Principle affects your Business Operations (Part 3)

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How companies can use the 80/20 Principle to raise profits

In this discourse of how the 80/20 principle affect your business operations we shall be looking at how the principle can be used to raise profits via the 80/20 Principle. We shall also be looking at hints on how to embed 80/20 Thinking into your business life, so that you can gain an unfair advantage over colleagues and competitors alike. If you are stumbling on the part 3 discourse for the first time you can read more on the part 1 and part 2 of how the 80/20 principle affects business operations.

We start with the most important use of the 80/20 Principle in any firm: to isolate where you are really making the profits and, just as important, where you are really losing money. Every business person thinks they know this already, and nearly all are wrong. If they had the right picture, their whole business would be transformed.

Why your Strategy Is Wrong

Unless you have used the 80/20 Principle to redirect your strategy, you can be pretty sure that the strategy is badly flawed. Almost certainly, you don’t have an accurate picture of where you make, and lose, the most money. It is almost inevitable that you are doing too many things for too many people. Business strategy should not be a grand and sweeping overview. It should be more like an under view, a peek beneath the covers to look in great detail at what is going on. To arrive at a useful business strategy, you need to look carefully at the different chunks of your business, particularly at their profitability and cash generation.

Unless your firm is very small and simple, it is almost certainly true that you make at least 80 per cent of your profits and cash in 20 per cent of your activity, and in 20 per cent of your revenues. The trick is to work out which 20 per cent.

Where are you making the most money?

Identify which parts of the business are making very high returns, which are just about washing their faces and which are disasters. To do this we will conduct an 80/20 Analysis of profits by different categories of business:

  • by product or product group/type
  • by customer or customer group/type
  • by any other split which appears to be relevant for your business for which you have data; for example by geographical area or distribution channel
  • by competitive segment.

Start with products. Your business will almost certainly have information by product or product group. For each, look at the sales over the last period, month, quarter or year (decide which is most reliable) and work out the profitability after allocating all costs.

How easy or difficult this will be depends on the state of your management information. What you need may all be readily available, but if not you will have to build it up yourself. You are bound to have sales by product or product line and almost certainly the gross margin (sales less cost of sales).You will also know the total costs for the whole business (all the overhead costs).What you then have to do is to allocate all the overhead costs to each product group on some reasonable basis.

The crudest way is to allocate costs on a percentage of turnovers. A moment’s thought, however, should convince you that this will not be very accurate. Some products take a great deal of salespeople’s time relative to their value, for example, and others take very little. Some are heavily advertised and others not at all. Some require a lot of fussing around in manufacturing whereas others are straightforward.

Take each category of overhead cost and allocate it to each product group.

Do this for all the costs, then look at the results. Typically some products, representing a minority of turnover, are very profitable; most products are modestly or marginally profitable; and some are really making large losses once you allocate all the costs.

The table below shows the numbers for a recent study conducted of an electronic instrumentation group.

$000
Product Sales Income Return on
sales (%)
Product group A 3,750 1,330 35.5
Product group B 17,000 5,110 30.1
Product group C 3,040 601 25.1
Product group D 12,070 1,880 15.6
Product group E 44,110 5,290 12.0
Product group F 30,370 2,990 9.8
Product group G 5,030 (820) (15.5)
Product group H 4,000 (3,010) (75.3)
Total 119,370 13,380 11.2

 Electronic Instruments Inc, sales and profits table by product group

We can see from the two figures that Product Group A accounts for only 3 per cent of sales, but for 10 per cent of profits. Product Groups A, B and C account for 20 per cent of sales, but for 53 per cent of profits. This becomes very clear if we compile an 80/20 Table or an 80/20 Chart, as in the tables below respectively.

We have not yet found the 20 per cent of sales that account for 80 per cent of profits, but we are on our way. If not 80/20, then 67/30: 30 per cent of product sales account for almost 67 per cent of profits. Already you may be thinking about what can be done to raise the sales of Product.

Business strategy should not be a grand and sweeping overview. It should be more like an under view, a peek beneath the covers to look in great detail at what is going on. To arrive at a useful business strategy, you need to look carefully at the different chunks of your business, particularly at their profitability and cash generation.

Groups A, B and C. For example, you might want to reallocate all sales effort from the other 80 per cent of business, telling salespeople to concentrate on doubling the sales of Products A, B and C and not to worry about the rest. If they succeeded in doing this, sales would only go up by 20 per cent, but profits would rise more than 50 per cent.

You might also already be thinking about cutting costs, or raising prices, in Product Groups D, E and F; or about radical retrenchment or total exit from Product Groups G and H.

Percentage of sales Percentage of profits
Product Group Cumulative Group Cumulative
Product group A 3.1 3.1 9.9 9.9
Product group B 14.2 17.3 38.2 48.1
Product group C 2.6 19.9 4.6 52.7
Product group D 10.1 30.0 14.1 66.8
Product group E 37.0 67.0 39.5 106.3
Product group F 25.4 92.4 22.4 128.7
Product group G 4.2 96.6 (6.1) 122.6
Product group H 3.4 100.0 (22.6) 100.0

 Electronic Instruments Inc, 80/20 Table

What about customer profitability?

After products, go on to look at customers. Repeat the analysis, but look at total purchases by each customer or customer group. Some customers pay high prices but have a high cost to serve: these are often smaller customers. The very big customers may be easy to deal with and take large volumes of the same product, but screw you down on price. Sometimes these differences balance out, but often they do not. For the group we are calling Electronic Instruments Inc the results are shown in the tables below.

$000
Customer Sales Income Return on
sales (%)
Customer type A 18,350 7,865 42.9
Customer type B 11,450 3,916 34.2
Customer type C 43,100 3,969 9.2
Customer type D 46,470 (2,370) (5.1)
Total 119,370 13,380 11.2

Electronic Instruments Inc, sales and profits table by customer group

A word of explanation about the customer groups. Type A customers are small, direct accounts paying very high prices and giving very fat gross margins. They are quite expensive to service but the margins more than compensate for this. Type B customers are distributors who tend to place large orders and have very low costs to serve, yet for one reason or another find it acceptable to pay fairly high prices, mainly because the electronic components bought are a tiny fraction of their total product costs. Type C customers are export accounts paying high prices. The snag with them, however, is that they are very expensive to service. Type D customers are large manufacturers who bargain very hard on price and also demand a great deal of technical support and many ‘specials’.

These figures reveal a 59/15 rule and an 88/25 rule: the most profitable customer category accounts for 15 per cent of revenues but 59 per cent of profits, and the most profitable 25 per cent of customers Yields 88 per cent of profits. This is partly because the most profitable customers tend to take the most profitable products, but also because they pay more in relation to their cost to service.

The analysis led to a successful campaign to find more A and B customers: the small direct customers and the distributors. Even taking account of the cost of the campaign, the result was very profitable. Prices for C customers (the export accounts) were selectively raised and ways found to lower the cost of servicing some of them, particularly by greater use of telephone rather than face-to-face selling. The D customers (large

Percentage of sales Percentage of profits
Customer Type Cumulative Type Cumulative
Customer type A 15.4 15.4 58.9 58.9
Customer type B 9.6 25.0 29.3 88.2
Customer type C 36.1 61.1 29.6 117.8
Customer type D 38.9 100.0 (17.8) 100.0

Electronic Instruments Inc, 80/20 Table by customer type

manufacturers) were dealt with individually: nine of these accounted for 97 per cent of D sales. In some cases technical development services were charged for separately; in others prices were raised; and three accounts were tactically ‘lost’ to the company’s most hated competitor after a bidding war. The managers really wanted the competitor to enjoy these losses!

 

 

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