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.

Using Pareto Charts to Improve Profitability

Vilfredo Pareto (1848-1923) was an Italian economist, philosopher, and industrialist who contributed much to the field of economics and quality.  Many of his economic philosophies led to the field of economics to move from one of social philosophy into a data intensive field of scientific research and mathematical equations.  However, as much as Pareto did for the study of economics and quality control, we can apply some of his theories and principles to help us run better businesses and help entrepreneurs make their businesses more profitable.

What Is It?

The Pareto Chart is one of the ‘Seven Basic Tools of Quality Control.’  It helps highlight the most important factors from among a group of many factors. In quality control, it is often used to represent the most common sources of defects or the highest occurrence of defects.  It is a simple bar chart that displays the number of occurrences on the left vertical axis and the category of occurrences on the horizontal axis.  While not required, you can add a right vertical axis which represents the cumulative percentage of the left axis to the total.  It’s self-explanatory when you see an example.

While this is a silly example, it shows the most common occurrence of reasons for students not having their homework in school. You can use this same chart tool to evaluate most any business process on which you can collect data.

Why Is This Important?

As an entrepreneur, this is a valuable tool for managing your business.  Even though you don’t care why students didn’t hand in their homework, you probably do care why you get complaints from your customer service or your delivery function, or why your accounting department can’t get the books closed on time or maybe what are you biggest overhead expenses.  There are as many applications as there are brilliant entrepreneurial minds to think of them.  Obviously, if you manufacture widgets or something else, you’ll want to use this quality tool on your manufacturing process.  However, you can also use it to help you improve any process in your business.

How To Use It

Identify any process within your company.  Collect data on the makeup of the issue.  Chart the data by number of occurrences, ranking the data in highest to lowest number order.  You don’t need to chart every issue, just those with the highest frequency.  Start working on the issue which is ranked first.  Make changes to your process and then collect more data.  Repeat the process until the first item is no longer the most frequent problem.  Once that happens, start working on the new number one problem.  You should be able to make improvements to those issues which cause you the most worries.  If you aren’t seeing any improvement, you probably aren’t getting to the root cause of the problem.  You may have identified and made changes to symptoms of the problem, without actually fixing the problem itself.  If you find that you aren’t making any progress, look at your causes again and try to get to the root cause of the problem.

Give Us Some Real Examples!

Here’s a list of a few problems I’ve run into on previous jobs, maybe you can think of other areas where this type of analysis would be helpful.

• Customer Service Errors
• Shipping Errors
• Overhead Expenses Have Grown
• Delays in Closing Accounting Period
• Meetings Run Long
• Low Volume of Website Orders

Summary

You can apply the Pareto chart to most any problem or process in your business to identify those issues that cause the most problems, cost the most money, or cause you customers to buy elsewhere.  It’s limited only by your imagination and ability to collect meaningful data.

 

P.S.  I'm a big fan of Pareto and will be looking at some of his other theories and tool and how they can be used to improve your business over the next few weeks.

Heilmeier's Catechism

George Heilmeier, born in 1936, was an electrical engineer with Ph.D.s in solid state materials and electronics.  He spent most of the 1970s working at the Department of Defense at the Defense Advanced Research Projects Agency (DARPA) and went on to work at and head several other companies such as Texas Instruments and Bellcore.  Heilmeier was awarded numerous prizes and awards from prestigeous science and engineering organizations and holds 15 patents.  He’s credited with being one of the pioneers to develop liquid crystal displays.

While George Heilmeier was indeed one of the brightest stars in the world of science and engineering in the second half of the 20th Century, he’s most well known for a set of criteria he developed for analyzing research projects and product development efforts.  Those criteria, know as Heilmeier’s Catechism, were aimed at project managers.  Heilmeier reckoned that any project manager should be able to answer these questions relating to project success before funding of the project or product would move forward.  The interesting thing about these criteria is that they can be applied to almost any kind of project, including starting a business.

Let’s look at the questions, and see how they might apply to starting or running a business:

• What are you trying to do? (Articulate your objectives using absolutely no jargon.)
  Sounds like the beginnings of a business plan to me.  What are the goals and objectives of the company described in plain language.
• How is it done today, and what are the limits of current practice?
  A SWOT analysis of your competition and industry will fulfull this question.
• What's new in your approach and why do you think it will be successful?
  Branding and a Marketing Plan are just the ticket to answer this question.
• Who cares?
  Who are your customers and what do they want.
• If you're successful, what difference will it make?
  What does it take to be successful and if you are, will you actually make any money.  It sounds like financial analysis to me.
• What are the risks and the payoffs?
  What are the assumptions that you used to build your financial statements and how conservative are your projections?
• How much will it cost?
  Have you done your cost analysis?
• How long will it take?
  A break-even analysis will answer this question.
• What are the midterm and final "exams" to check for success.
  What a novel approach.  Let’s build in some early and mid-term success measures to make sure we’re on course to meet our plan objectives.

What we find is that Heilmeier’s Catechism is nothing more than standard business planning.  Perhaps it’s a ‘chicken or the egg’ issue; but really, who cares?  Heilmeier has applied common sense and standard business practices to the area of scientific inquiry.  And we can use his model to double check our plans to insure our business plans and projects are on track for success.

13 Ways to Bootstrap Your Start-Up Capital

Starting a business without borrowed money is an awesome thing.  The lack of readily available funds forces you to concentrate on the basics, maximizing resources to save capital for when you really need it.  Your discipline is sharpened and you don’t waste resources on stuff that doesn’t translate to bottom line success.  But sometimes, business owners need to borrow money to grow or start their businesses.  I recommend borrowing money as a last resort, and when you do borrow, utilize your bootstrapping ways as a first line of defense.  Only resort to banks and other official sources when all avenues have been exhausted.

So what are the bootstrapping ways of borrowing money and what other unofficial sources are out there other than banks?  I’m glad you asked…

1. e-Bay – Sell your stuff.  You’ve probably got an attic or basement or both full of stuff, junk mostly.  But some of it could be dusted off and sold on e-Bay or other auction sites, in a local antique or flea market or at a garage sale.  Remember the adage, “One man’s trash is another man’s treasure.”  
2. Pawn Stars – Pawn valuable stuff you don’t want to sell.  Okay, this isn’t a great plan for long-term financing of your business, but it could be used to raise a small amount of capital for an immediate need that could be repaid with other more long-term sources of funding.  It’s a way to raise capital quickly, in a pinch.
3. Car Equity – Tap into your car’s equity.  Refinance of finance your vehicle to get the ‘equity’ out of it.  Just remember, as your vehicle gets older, its value will decline and so your opportunity to get cash from it.
4. Credit Cards – Borrow money off your credit cards.  While this technique isn’t as readily available as it once was, you can use personal credit cards to pay your business bills.  Apply for cards and use balance transfers to pay off older balances with new cards at introductory rates.  I have a friend who built a house using credit cards to finance the construction.  He paid the cards off with a permanent first mortgage after the construction process was over.  This is a short-term solution as credit cards have high interest rates.  This also isn’t a solution for individuals who have no money management skills.  Wait!  On second thought, starting a business isn’t a good option for individuals with no money management skills.
5. Family – Borrow from your family.  An infamous local entrepreneur is often quoted as saying, “Don’t borrow money from people you sit across the Thanksgiving table from.”  The downsides of borrowing money from family are too many to enumerate.  However, the transaction can be fast and easy if you have a family member who has the extra cash and is interested in investing in your business.  There are two keys for borrowing money from family.  First, don’t borrow money that the family member will likely need to live on.  Unless you plan to support the family member and be responsible for all the bad things that happen to them when their living expense money disappears because your business couldn’t repay the money when expected or needed.  And second, treat it like a bank loan.  Get a note document on-line and modify it to meet your needs and then live by its terms.
6. Friends – Borrow from your friends.  SEE #4 above for ground rules.
7. Local ‘Angels’ – Borrow from local business acquaintances and professionals.  Most ever city and town has a group of wealthy citizens, whether they are retired businessmen and women or professionals or maybe they inherited their wealth.  The point is these people have more money than they have good options for investing it.  If you have an interesting plan and can compellingly sell your idea, these folks may be just the ticket.  You’ll need official legal documents, but it’s significantly easier than borrowing from a bank.
8. Vendors – Borrow money or products from your vendors.  If you have a major or potentially major vendor, they might be interested in help you establish a business.  These vendors have a vested interest in your success since you’ll be buying must of your product from them.  In some cases, these vendors maybe willing to help you get your business established by either loaning you money, product, location or other resource to help you get in business.
9. Factoring – Sell your accounts receivable.  Factoring may not be a great way to get into business, but is can help in the beginning.  If you have some large accounts receivable from a special job or large order, consider factoring.  You sell your receivable to a third party firm in exchange for cash.  You’ll receive between 70% - 90% of the value of the receivable, depending on the risk involved.  It’s an expensive financing method, but might help you out in a pinch or allow you to take a huge job that you wouldn’t have been able to take otherwise.  Just remember to factor in the cost in the analysis.
10. Clients – Borrow from clients or have them pre-pay for services.  While this may seem like a dumb move, your clients may be intimately knowledgeable of your start-up plan and more than just a disinterested third party in your success.  Your client may help you to get started so that you can provide products and services to them.  If you have an excellent relationship with a potential client who could benefit from your success, maybe they’ll help you get started.  If they aren’t interested in loaning you cash, maybe they’ll pre-pay for products or services at a slight discount to help out.  I don’t recommend that you ask random clients to borrow money, but for those clients with whom you have a special relationship, this could be a great option.
    When all else fails, consider these options.
    
11. Investments/401(k)/IRA – Borrow from or liquidate retirement accounts. You may have options for borrowing from or cashing out investment and retirement accounts.  These are more last available option type choices, but they are available if you have money invested in these type accounts.  Remember, withdrawing money from a pre-tax retirement account will mean tax penalties and income taxes have to be paid on these withdrawals.  Factor these costs into the equation and understand the consequences before using this source.
12. 529 College Savings Plan – Liquidate or borrow from your child’s education fund.  While using your child’s college savings to start a business might not be such a great idea; it might have to do in a pinch.  This is another last line of defense consideration.  Just be prepared for your kid to work her way thorough college if your business doesn’t make it.  On the other hand, you’ll be especially concerned about achieving success and paying this money back before her college years begin.
13. Home Equity – Tap into your home’s equity.  Either refinance your home mortgage or take a second mortgage or equity line of credit to utilize the equity in your home.  I consider this a second tier option due to the possible side affects should your business fail.

Have you got some other ideas?  Let's hear them.

On A Roll

Sorry for the pun, I couldn't resist.  Apparently, The Toilet Paper Entrepreneur, Mike Mikchalowicz, really likes what I have to say.  In his latest blog post for today, March 18, 2010, yours truly is listed as the #2 contributor.  This post, 81 Strategies to Fix a Bad, Falling Apart Business Partnership, discusses this all to often occurrence.  You and your partner have this great idea, you form a business and quickly go about making money.  However, you probably didn't fully appreciate the necessity of documenting how you would do business together and deal with the issues that will naturally come up in a partnership.  Now, instead of loving each other like you did only a few short months ago, you are at each others throats.  What do you do now?  Go read the blog post for ideas from 81 different business pro's from different walks of business life.

Got some ideas that weren't mentioned?  Leave a comment and let's discuss.

Toilet Paper Blogs

Bestselling author and business start-up champion Mike Michalowicz, author of The Toilet Paper Entrepreneur and The Toilet Paper Entrepreneur blog paid me a tremendous honor last week by including me in a recent blog entry.  He was writing a blog entry about celebrating entrepreneurial success and included my suggestion as entry #7, check it out. 

Mike has a unique style of presenting his material.  Some find it a little sophomoric, but that's just his shtick, and it has worked.  People are reading his blog and his book and booking him for TV interviews and speaking engagements.  His real value come from helping entrepreneurs identify their unique value proposition, their values, identifying the customer and providing a product or service in a narrow niche.  Sound familiar?  If you're a client or use our coaching services you've heard this before. 

How can you possibly hope to deliver the best of you to your customers, if you don't know what that is?  And even after you figure that part out, you can't offer it to the world, most of the world could care less.  Clearly identifying your customer is one of the most important aspects of your business success.  From knowing where to physically locate to running an effective marketing campaign, you can't do that without knowing your customer.

If you have a chance, check out Mike's blog.  It's entertaining and packed full of resources for the small business entrepreneur.

Break Even Analysis

Break-even is one of the most commonly used methods for evaluating a new business enterprise or new product line or manufacturing facility.  It’s a tool for analyzing how sales revenue, profit and expenses vary with changes in one of the variables.  The break-even point is an equalibrium where sales revenue is equal to costs.  At the break-even point, no profits are earned and no losses are incurred.  Break-even is a cash flow tool (so we will not consider non-cash expenses in the calculation) that is easy to calculate.  It is widely used in production management and by cost and management accountants and can prove useful in determining whether to make an investment in a new plant, a specific piece of equipment or a whole business entity.

One of the drawbacks of the break-even analysis is the assumption that nothing changes.  That is, the model assumes that the conditions that were present during the calculation do not change.  Of course, everything changes constantly.  Sales prices are affected by overall sale volumes and costs of raw materials, labor and transportation costs.  The relationship between Therefore, the break-even must be recalculated on a regular basis in order to keep the information relevant and useful.

In order to compute the break-even point, we need to know the following variables:

• Annual Sales Revenue
• Gross Profit Margin
• Operating Expenses (less depreciation)
• Annual Debt Service

 With these figures in hand, we can caluate the various components of break-even.

Break-Even Sales:  (Operating Expenses + Annual Debt Service) 

                Gross Pofit Margin %

Break-Even Gross Margin:  (Operating Expenses + Annual Debt Service) 

                                                                            Sales

Break-Even Operating Exp.:  Sales × Gross Pofit Margin %