The Pareto principle, also known as the 80/20 rule and the law of the vital few, states that, for many events, approximately 80% of the effects come from 20% of the causes. The principle was named after the Italian economist Vilfredo Pareto, who observed in 1906 that 80% of the land in Italy was owned by 20% of the population; he developed the principle by observing that 20% of the pea pods in his garden contained 80% of the peas. Interestingly, this observation translates to business extremely well; for example, “80% of your revenue will come from 20% of your clients.” The Pareto analysis is a formal technique for finding the changes that will give the biggest benefits. It is useful where many possible courses of action are competing for your attention. So, knowing the basics of the 80/20 rule, how can you use this in your own business?
Problem Solving – step by step
First, list the business problems you need to solve. If you have a long list, group any related problems together. Then, apply a score to each group – the scoring method will depend on the problem you are trying to solve. For example, if you are trying to improve profitability, score the options based on the profit that each group could possibly generate. If you are trying to improve customer satisfaction, you might choose to score each problem with the number of complaints received. The first problem to work on will be the one with the highest score, as this will give you the greatest benefit.
Analysing your client base
Who are the clients that occupy the top 20% of your customer base? Here are some quick steps to get you started on your own 80/20 client analysis:
1. Print out your sales ledger for the most recent financial year by client.
2. Save as a spreadsheet.
3. Sort the clients by size, number of customers and total sales value.
Analysing the results
Is your business heavily reliant on the top 5-10% of your client base? If one or two customers took their business elsewhere, would your business lose a large proportion of total sales? Are you spending a lot of time serving smaller customers, when they only contribute only a small percentage of sales? If so, one of the key questions you should be asking is, “Could time spent serving 80% of the customer base be better spent on the larger customers?” The ensuing discussion should focus on strategies to move customers in the large bracket to extra large, and then turning medium sized customers into large customers.
Another use of 80/20 analysis would be to help with cash collection. When faced with a long list of clients we need to chase for payment, we should focus more of our efforts on collecting cash from the top 20% of our client base which usually accounts for a high percentage of the total monies outstanding, thereby utilising our time more efficiently.
The 80/20 analysis can be a real eye-opener. These are only a few examples of using it in your business – it shows the lack of symmetry that almost always appears between effort put in and results achieved. We know that what you can measure you can manage, and, armed with this information, your management decision making will improve dramatically.
If you’d like to find out more about pareto’s law, also known as the 80-20 principle, this is a great book by Richard Koch The 80/20 Principle: The Secret of Achieving More with Less
About the author: Kay Daniels. Kay has twenty years’ accountancy experience across a wide range of sectors. She is the founder and managing director of Daniels Accountancy, based in Ealing, West London. Daniels Accountancy provides bespoke accountancy and business support to its clients – subscribe to their newsletter – www.danielsaccountancy.com and follow Kay on Twitter