The concept was developed by the Italian economist Vilfredo Pareto. (Yeah, I know, Pareto wasn’t the greatest guy in the world since some of his theories helped in the development of fascism– he lived from 1848 to 1923).
Despite that unfortunate contribution, he did make one very good contribution. He observed that twenty percent of the Italian people owned eighty percent of Italy’s accumulated wealth. The Pareto Principal basically states the relationship between input and output is not balanced. Management can learn from the Pareto Principle regarding effectiveness and diminishing returns in terms of effort, expense and time.
Let’s look at this in terms of managing a profit center. While many ad agencies, media companies (and businesses in general) keep chanting the constant paternoster “develop new business” it is a very misguided message according to the Pareto Principle. I have seen the Pareto Principle hold true for many companies I have worked and consulted with over the years.
Any organization has a fixed inventory of time, effort and personnel they can employ during a given time period. By extending too much effort on “getting new business” a company could be letting the fox in the henhouse. The “opportunity costs” of a disproportionate effort on new business means that other efforts must be put aside. The most heinous crime is a company’s neglect in super-serving its most important customers in an attempt to get new business. The “most important” customers are those customers (the 20% or Very Few) which account for approximately 80% of any company’s business. (The numbers do not always work out exactly in an 80/20 proportion, but its pretty darn close in most cases).
This isn’t to say that new business should be abandoned or ignored. However, new business efforts need to be put into the context of the expense of losing an important customer. Witness the statement below:
“Customer defections have a surprisingly powerful impact on the bottom line. They can have more to do with a service company’s profits than scale, market share, unit costs, and many other factors usually associated with competitive advantage. As a customer’s relationship with the company lengthens, profits rise. And not just a little. Companies can boost profits by almost 100% by retaining just 5% or more of their customers.”
-Harvard Business Review, September-October 1990. “Zero Defections: Quality Comes to Services.
How does the Pareto Principle work in real life? To give one “real world” example, one business I worked with had 259 cash accounts over a year’s period of time. When an account analysis of their customers was complete, it was revealed that the top 51 spenders (the top 20%) accounted for 71% of the company’s total revenue. Obviously, the cost of losing just five of these 51 accounts would be very costly (and very difficult to replace with new customers). Don’t think for a moment that the company’s competition isn’t trying to woo all 51 of those accounts either. What if they don’t woo them completely, but whittle off some of the business, eroding the company’s share of business? Still not a good scenario is it? The only way to ensure against this is to know your key customers’ needs and to keep them happy. Sounds simple, but most bonehead managers don’t realize the importance of this very simple concept.
If the services provided to any of those top 51 accounts isn’t up to par, then the likelihood of losing them increases. I don’t know about you, but I’d rather spend most of my time protecting, super-serving and further developing the “top 20 percent” than wasting time and effort “getting new business” (unless I had a realistic new business plan– but as you know, most new business goals are ridiculously unrealistic). The Pareto Principle is not only alive and well in business situations, it thrives in your everyday life too:
- Are you wearing 20% of your shoes 80% of the time?
- Look in your closet. Are you wearing about 20% of your wardrobe the vast majority of the time? (We used to joke at work when people would wear clothes that we rarely saw them wear— the rarely worn garments were referred to as a “low rotators”).
- Are you accumulating 80% of your yearly car mileage by driving only 20% of all the roads that you drive?
- Is 80% of your workday spent on activities that are unproductive?
- Are 20% of your products or services accounting for 80% of your revenue?
- If you manage people, are 80% of your interruptions coming from 20% of your employees?
- Are 80% of your customer complaints come from 20% of your customers?
- Do 80% of your advertising results coming from 20% of your ad expenditures?
- Is 80% of your website’s activity coming from 20% of the people that visit it?
It may be a wise investment of time to take inventory and make sure your efforts are as productive as possible. We all have a fixed inventory of time and effort. Superserving your “Top 20” is the key to profitability.
Source: Arthur W. Hafner, Ph.D., M.B.A.