Monday, April 19, 2010

The Pareto Principle and Business Profitability


How to Use the 80-20 Rule to Improve Your Business

This is a follow-up to the April 14th post about using Pareto Charts to improve profitability in your business.

Vilfredo Pareto (1848-1923), an Italian economist, philosopher and industrialist, created a mathematical formula to describe the unequal distribution of wealth.  In a paper written in 1906, he observed that approximately 20% of the Italian population owned 80% of the wealth in their country.  Pareto’s Principle, sometimes known as the 80/20 Rule, was made famous by U.S. quality poineer Dr. Joseph Juran in the 1930s and 40s.  Dr. Juran recognized a universal principle he called the “vital few and trivial many.”  Mostly as a result of Dr. Juran’s work showing that 20% of something is usually responsible for 80% of the results, Pareto’s Principle or the 80/20 Rule became widely know and adopted by scientists in many different disciplines.

What Is It?

The 80/20 Rule suggests that in most anyting, the few (20%) are vital and the many (80%) are trivial.  In Pareto’s theory, he suggested that only 20% of the population held 80% of the wealth.  In your business, it might mean that 80% of your warehouse space is taken up by 20% of your inventory.  Customer service professionals understand that 20% of the customers are responsible for 80% of the order volume and additionally, 80% of the complaints come from only 20% of the customers, though probably not the same 20%.

Why Is It Important?

Unless you’re asleep, you probably already understand why this is important to your business.  If not, keep reading.

The Pareto Principle teaches us that most of our business problems (80%) come from a small source (20%) and just as importantly, that a small group of customers (roughly 20%) generate most of our revenue (80%).  As a business owner, the principle suggests that the bulk of your daily activity, in terms of time, is trivial and that only a small amount of your daily calendar actually contributes to your wallet.

How Do I Use It?

Let’s use a couple of specific examples to illustrate how to use the Pareto Principle to improve your business profitability.

Example 1 – Applying the 80/20 Rule to your sales revenue suggests that 80% of your net sales are generated by only 20% of your customer base.  Do the math yourself and confirm the rough estimates.  It may be that 23% of the customers represent 84% of your revenue or another variation, the exact percentages are not important.  What’s important to recognize is that a vital few customers are responsible for the bulk of your sales.  There are at least two very important take-aways from this analysis in your own business: 1) you’d better make sure you are taking care of the top 20% of your customers and keeping them satisfied, and 2) if you want to grow you business, look to the other 80% of customers.  They represent the best chance to generate more repeat sales or to cross-sell other products or services.  It’s likely that these 80% of customers are not buying up to their potential.

Example 2 – Applying the 80/20 Rule to your customer service function suggests that 80% of the complaints come from 20% of the customers.  It also suggests that 80% of your problems in properly taking, filling and delivering customer orders correctly, come from 20% of the activity.  Like using the Pareto Chart, this example requires collecting data (You really should already be doing this!) about the complaints in your order fullfilment function.  If you use a bar chart to display the complaints by type (this sounds familiar) and then rank them by frequency of occurrence (yes, I’m sure I’ve read this somewhere before), the top 20% of complaint types should account for 80% of the number of compaints.   Start with the top complaint type, get to the root cause of the issue and correct the problem.  Put the correction in place and track the results.  Wash, rinse and repeat.

Summary

You can apply the Pareto Principle to most any aspect of your business.  By using the 80/20 Rule to observe the track the problems hurting your customer relationships and opportunities to improve profitability and reduce costs, making improvements to your processes and tracking the results, you’ll be more efficient and profitable in no time.

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