Pay attention to Pareto

By Mark Crawford

Have you ever noticed that:

20 percent of your sales staff generate 80 percent of your sales?

20 percent of your employees cause 80 percent of your problems?

20 percent of your stock takes up 80 percent of your warehouse space?

20 percent of your products/services bring in 80 percent of your profits?

If you have, then you know about the Pareto Principle, otherwise known as the 80/20 Rule: That a natural imbalance exists between inputs and outputs, or between efforts and results. A minority of causes, inputs or efforts (usually about 20 percent) leads to a majority of the results, outputs or rewards (about 80 percent). This ratio is almost always about 80/20. Acting on this rule helps any company, in any industry, identify its core strengths and weaknesses. The next step becomes designing a strategy to maximize your most productive forces and minimize or eliminate the negative influences.

"The 80/20 rule allows us to see if we are spending our time wisely, where it will generate the most profit," said Stephanie Barganz, partner at Bodilly CPAs and Consultants LLP. "We use a balanced scorecard approach that evaluates financials, customer base, internal operations and employees. The 80/20 rule can be applied to each one of these areas — for customer base, for example, 80 percent of your profit comes from only 20 percent of your customers. Who are those customers? It's surprising how few executives really know much about their top customers."

"I've not met a CEO who has not heard of the 80/20 principle," said Madison-based Stratagex consultant Joe Hahn. "Yet, very few of them understand it well, or know what to do with it."

As a former executive with Illinois Tool Works, Hahn knows 80/20 inside and out. This $18 billion multinational company started using 80/20 in the 1980s to improve efficiency and competitiveness. Over the last 25 years, the company posted an average 19 percent annual shareholder return — which it attributes to the Pareto Principle.

"Everyone uses 80/20 to some extent, whether it's for approaching opportunities or problems," said Gordon Meicher, president of Meicher & Associates LLP. "For example, 20 percent of your customers create 80 percent of the profits or 80 percent of your problems. It immediately gives you something to target. The best solution may be getting rid of some of those troublesome clients because they are just too difficult to work with and are wasting your resources."

"There are some simple tools and strategies for evaluating your products or services, clients, industries, markets and people," said Neil Fauerbach, partner and director of business development and marketing for Smith & Gesteland LLP, an accounting and business consulting firm that conducts 80/20 analysis for its clients.

"It is a very data-driven process that takes the emotion out of decisions. We determine where they earn their money, and more importantly, where they throw it away. The resulting changes we make often involve pricing, policies such as shipping and order quantity, and sales. That said, it's not a slash-and-burn process — we are respectful of the client's culture, work force, customers and suppliers."

"The first step in 80/20 is making a list of customers and the dollar amount of revenue they create, from highest to lowest," said Anita Matcha, a Smith & Gesteland strategic adviser who has helped several clients implement 80/20. "Then divide that list into quarters. Invariably, the first 25 percent (quartile) of customers generates 89 percent of the profit and the second quartile generates 7 percent; the third and fourth quartiles (the bottom half of the revenue list) generate the remaining 4 percent. This ratio is nearly always the same, regardless of company."

Armed with this critical information, the company then devises a strategy for treating the top two quartiles in better ways. "Quartile reports show how dependent you are on the top quartile," continued Matcha. "These clients need more attention, and staff must make considerable effort to understand their businesses at a deeper level. If they do, they'll be less likely to lose them to the competition, and more likely to draw more business from them."

The hardest part of the process is the cultural change. Employees have been taught that all business is good business, and to treat all the customers equally.

"It's easy to backslide," Matcha said. "Keep running the numbers. It takes three to five years of consistent application to transform an entire company; business becomes simpler and more profitable, with more attention being paid to the 'critical few' customers who ultimately drive revenue and growth. Some clients have increased their profitability by 1,000 percent in a year."

Tom Milliken, principal and head of tax practice for Suby von Haden and Associates, cautions about segmenting clients according only to the revenues they generate.

"To size up the value of a client, we look at several things," he said. "Do we get referrals? How many of our services do they use? Do they pay their bills on time? Are they easy to serve? All these things need to be factored into the equation.

"Because A clients are easier to serve, the natural tendency is to spend more time on B and C clients, when it could be the opposite. You also never know when a low-revenue client will become a high-revenue client, so it is important to know where they're headed in their business."

Before offering 80/20 analysis to its clients, Smith and Gesteland thought it should try it out internally.

"We were very concerned about employee and partner burnout," said CPA and partner Dennis Breunig. "Our people in many cases were just being asked to do too much. Worse yet, in many cases, not only were people working too hard, but the financial results were not as good as we wanted them to be. We were expecting that 80/20 would improve our focus so that we could work less and produce more."

And it worked. "Our quartile analysis dramatically showed us how much time and energy was being directed towards efforts that produced so little revenue or profit," said Bruenig. "Roughly 25 percent of our efforts had a minimal impact on profitability and also came at our very busiest time of the year."

The company developed a very clear and simple strategic plan. "We established fewer goals, not more goals, and then were passionate about executing those goals. One example of a change was revising our new client acceptance criteria. We are now very careful before accepting new business, because we want to be certain that it is a good fit. This one change alone resulted in huge improvements to our firm. The total number of new clients decreased as a result, but the revenue and profit from the new clients increased."

"There is never a bad time to start 80/20," Hahn said. "With this economy, I can't think of a better time than right now. 80/20 allows profitability improvement without commensurate revenue growth, which is very appealing at the moment."

By eliminating/treating differently the low-revenue-producing clients, companies can solve financial problems quickly and still be strategic with excellent growth potential. Major improvements in financial position can occur in as little as one month, and certainly within a quarter.

"Most companies invest $10K to start, $20K to jump in, and then $100K to really roll," said Hahn. "Those investments get paid off in full in a month. The biggest thing to remember is that 80/20 never, never fails."

The Pareto Principle

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