It may pay to drop customers

Ever consider dropping customers or raising prices until they drop you?

For many companies, that radical step is a sound growth strategy.

The Pareto Principle (also known as the "80-20 Rule") captures the observation that 20 percent of something often accounts for 80 percent of the results. In business, roughly 80 percent of a typical product line will be consumed by 20 percent of the customers; 80 percent of quality incidents usually come from 20 percent of the problems.

Here's the strategic question for business executives, then: "Since 80 percent of your gross margin or operating profit likely comes from only 20 percent of your customers, why keep the other 80 percent of your customers?"

In consumer goods markets, the low-margin 80 percent can often be served with little or no incremental cost. (The marketing and sales expense to attract moms who buy a week's supply of Lunchables will also attract the multitude of moms who purchase one Lunchable every few weeks.)

It's not smart to turn away less-frequent buyers unless securing their business requires expenditures offering inadequate financial payback. For example, some incremental channels of distribution are not worth their cost.

Consider three attributes

Business-to-business markets - especially those with customized offerings - are very different. Three attributes of business-to-business markets make dropping the low-margin 80 percent of customers a potentially smart strategic move.

• First, businesses provide more unique, competitive value for customers at the top of their margin list than for those at the bottom (where price-driven customers usually reside). It makes no sense expending limited resources on customers that barely pay a profit margin when there are prospects who will generously compensate your company for helping their business succeed.
• Second, additional capacity - especially in manufacturing companies - is expensive and increases the risk of negative returns. Why grow sales by adding capacity when you can grow profits just as readily by replacing lower-margin customers' revenue with additional revenue from new or existing high-margin customers?
• Third, business-to-business markets often require direct selling and responding to requests for proposals. Strategically, it doesn't make sense to invest time in accounts that will likely end up in the 80 percent pile, if you win them at all. Marketing and sales resources would be better directed toward fewer prospects that mirror the earnings potential of top-margin accounts.

There are exceptions to these recommendations. Proactively taking a risk on a low-margin customer can turn out tremendously well. A client of mine once landed a target account via an online auction and has since built a handsome business with this market leader.

Some companies seek capacity-filling work as a tactic during market downturns or as filler before landing more desirable accounts.

Other companies accept low-margin accounts to secure economies of scale. While these are sound reasons, be wary.

Securing accounts only for their volume can lead you into the trap of filling a plant with commodity work rather than securing additional top 20 percent accounts. A vicious cycle of growing by adding capacity to serve price-driven buyers, who then demand more capacity, will surely erode your company's ability to thrive.

To remain strategically smart, resist capacity investments or system changes for customers without high-profit potential and reward sales representatives on margin, not volume.

What's similar among your top 20 percent of accounts, and what - other than margin - differentiates them from accounts at the bottom?

The Pareto Principle reveals that the "bottom 80 percent" customers carry an opportunity cost - they absorb resources that might be more profitably deployed elsewhere.

What customers should you stop serving today?

Kay Plantes is a Madison economist, strategy consultant and executive educator.