How the 80/20 Principle affects your Business Operations(Part 2)

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CORPORATE SUCCESS NEEDN’T BE A MYSTERY

In contrast to the theory of perfect competition, the 80/20 theory of the firm is both verifiable (and has, in fact, been verified many times) and helpful as a guide to action. The 80/20 theory of the firm goes like this:

  • In any market, some suppliers will be much better than others at satisfying customer needs. These suppliers will obtain the highest price realizations and also the highest market shares.
  • In any market, some suppliers will be much better than others at minimizing expenditure relative to revenues. In other words, these suppliers’ products will cost less than other suppliers, for equivalent output and revenue; or, alternatively, they will be able to generate equivalent output with lower expenditure.
  • Some suppliers will generate much higher surpluses than others. (I use the phrase ‘surpluses’ rather than ‘profits’, because the latter normally implies the profit available for shareholders. The concept of surplus implies the level of funds available for profits or reinvestment, over and above what is needed normally to keep the wheels turning.) Higher surpluses will result in one or more of the following:

(1) Greater reinvestment in product and service, to produce greater superiority and appeal to customers;

(2) Investment in gaining market share through greater sales and marketing effort, and/or takeovers of other firms;

(3) Higher returns to employees, which will tend to have the effect of retaining and attracting the best people in the market; and/or

(4) Higher returns to share-holders, which will tend to raise share prices and lower the cost of capital, facilitating investment and/or takeovers.

  • Over time, 80 per cent of the market will tend to be supplied by 20 per cent or fewer of the suppliers, who will normally also be more profitable.

At this point it is possible that the market structure may reach equilibrium, although it will be a very different kind of equilibrium from that beloved of the economists’ perfect competition model. In the 80/20 equilibrium, a few suppliers, the largest, will offer customers better value for money and have higher profits than smaller rivals. This is frequently observed in real life, despite being impossible according to the theory of perfect competition. We may term our more realistic theory the 80/20 law of competition.

Apparently small differences create large consequences. A product has only to be 10 per cent better value than that of a competing product to generate a sales difference of 50 per cent and a profit difference of 100 per cent. One implication of the 80/20 theory of firms is that successful firms operate in markets where it is possible for that firm to generate the highest revenues with the least effort

But the real world does not generally rest long in a tranquil equilibrium. Sooner or later (usually sooner), there are always changes to market structure caused by competitors’ innovations.

  • Both existing suppliers and new suppliers will seek to innovate and obtain a high share of a small but defensible part of each market (a ‘market segment’). Segmentation of this kind is possible by providing a more specialized product or service ideally suited to particular types of customer. Over time, markets will tend to comprise more market segments.

Within each of these segments, the 80/20 law of competition will operate. The leaders in each specialist segment may either be firms operating largely or exclusively in that segment or industry generalists, but their success will be dependent, in each segment, on obtaining the greatest revenue with the lowest expenditure of effort. In each segment, some firms will be much better than others at doing this, and will tend to accumulate segment market share as a result.

Any large firm will operate in a large number of segments, that is, in a large number of customer/product combinations where a different formula is required to maximize revenue relative to effort, and/or where different competitors are met. In some of these segments, the individual large firm will generate large surpluses, and in other segments much lower surpluses (or even deficits). It will tend to be true, therefore, that 80 per cent of surpluses or profits are generated by 20 per cent of segments, and by 20 per cent of customers and by 20 per cent of products. The most profitable segments will tend to (but will not always) be where the firm enjoys the highest market shares, and where the firm has the most loyal customers (loyalty being defined by being longstanding and least likely to defect to competitors).

  • Within any firm, as with all entities dependent on nature and human endeavor, there is likely to be an inequality between inputs and outputs, an imbalance between effort and reward. Externally, this is reflected in the fact that some markets, products and customers are much more profitable than others. Internally, the same principle is reflected by the fact that some resources, be they people, factories, machines or permutations of these, will produce very much more value relative to their cost than will other resources. If we were able to measure it (as we can with some jobs, such as those of salespeople), we would find that some people generate a very large surplus (their attributable share of revenue is very much greater than their full cost), whereas many people generate a small surplus or a deficit. Firms that generate the largest surpluses also tend to have the highest average surplus per employee, but in all firms the true surplus generated by each employee tends to be very unequal: 80 per cent of the surplus is usually generated by 20 per cent of employees.
  • At the lowest level of aggregation of resources within the firm, for example an individual employee, 80 per cent of the value created is likely to be generated in a small part, approximately 20 per cent, of the time when, through a combination of circumstances including personal characteristics and the exact nature of the task, the employee is operating at several times his or her normal level of effectiveness.
  • The principles of unequal effort and return therefore operate at all levels of business: markets, market segments, products, customers, departments and employees. It is this lack of balance, rather than a notional equilibrium, that characterizes all economic activity. Apparently small differences create large consequences. A product has only to be 10 per cent better value than that of a competing product to generate a sales difference of 50 per cent and a profit difference of 100 per cent.

One implication of the 80/20 theory of firms is that successful firms operate in markets where it is possible for that firm to generate the highest revenues with the least effort. This will be true both absolutely, that is, relative to monetary profits; and relatively, that is, in relation to competition. A firm cannot be judged successful unless it has a high absolute surplus (in traditional terms, a high return on investment) and also a higher surplus than its competitors (higher margins).

A second practical implication for all firms is that it is always possible to raise the economic surplus, usually by a large degree, by focusing only on those market and customer segments where the largest surpluses are currently being generated. This will always imply redeployment of resources into the most surplus-generating segments, and will normally also imply a reduction in the total level of resource and expenditure (in plain words, fewer employees and other costs).

Firms rarely reach the highest level of surplus that they could attain, or anywhere near it, both because managers are often not aware of the potential for surplus and because they often prefer to run large firms rather than exceptionally profitable ones.

A third corollary is that it is possible for every corporation to raise the level of surplus by reducing the inequality of output and reward within the firm. This can be done by identifying the parts of the firm (people, factories, sales offices, overhead units, countries) that generate the highest surpluses and reinforcing these, giving them more power and resources; and, conversely, identifying the resources generating low or negative surpluses, facilitating dramatic improvements and, if these are not forthcoming, stopping the expenditure on these resources.

these principles constitute a useful 80/20 theory of the firm, but they must not be interpreted too rigidly or deterministic-ally. The principles work because they are a reflection of relationships in nature, which are an intricate mixture of order and disorder, of regularity and irregularity.

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