The Pareto principle, generally known as the 80–20 rule, states that, for many events, roughly 80% of the effects come from 20% of the causes. Applying the principle in business analysis can prove to be a very effective business tool, and one of its many areas of application is in that of sales.
It is a common opinion in business; that 80% of an organisation’s sales come from
20% of their clients, thus when applying the 80/20 rule to a customer base, it is often thought that the 20% of the customer base which provide the most profitable income is the area on which the business should concentrate, rather than the 80% which have low profitability.
However, it should be considered that the 80% of the customer base, also contribute to overall income production, but that some customers are more productive than others. Before making any rash decision regarding the customers which constitute the less profitable 80%, it is important to consider how exactly those customers contribute to the interests of the business.
On first glance it might seem that following the application of the 80/20 rule, customers could easily be divided into those which are more profitable, and those which are less so.
This often results in the simplistic idea that it is better to concentrate time and investment where it already shows more profitable results rather than where the results are less profitable. However increasing investment in such a manner and to effectively starve or ignore the less profitable areas without understanding why they are less profitable, can be counterproductive and potentially expensive.
Businesses exist to make money by anticipating and satisfying customer demand. For the commercial manager responsible for producing a continuous stream of profitable income for the long-term benefit of the organisation, balancing the need to make profitable income against the interests of the customer is paramount. Ultimately it is the customer which has the power, because they have the money. The objective of the commercial manager is to maximise the level of profitable income for the long term while minimising the use of assets and investment. by managing all resources efficiently and effectively.
Before making any decisions that might adversely affect the customer base, there are a number of questions and actions that the commercial manager should consider:
- How many customers are there, that constitute the 20% and the 80%? It is important to know how many customers there are and whether or not the customer base is growing, or shrinking?
Concerning the 80% of the customers, commercial managers should consider:
- Where are they? Knowing where customers are geographically located and the potential for growing the customer base in those areas is important when considering transport and delivery opportunities and costs.
- Is the geographical distribution of customers a factor in their lower profitability? Are there other potential customers in the vicinity of isolated customers that collectively could be developed to greater profitability?
- What do these customers buy? How much do they spend? How frequently? This information may enable changes to be made to the service which would benefit the client and improve the level of profitable income produced.
- Are all customers being offered the right product mix for them? Would customers benefit from other products or services that could be provided, - how do you know?
- Consider what might be done for the smaller customer that would encourage them to increase their level of purchase of their existing orders. Could their order size be increased with the encouragement of discounts or improved credit facilities as an incentive?
- Do all customers meet the company’s trading requirements in size, order size capability, location? Can this be improved by altering conditions or servicing through other methods?
- Are credit terms suitable or would a change improve cash-flow and profitability?
- Analyse and establish the real reasons behind low profitability with the customers that comprise the less profitable 80%?
- Establish if and how the admin/service costs of the 80% might be reduced without affecting the customers? Ask the workforce how they would improve the administration system that they work with.
All customers contribute to the size of the business in their contribution to its overall market share. That size of the organisation affects its influence in the market, which also affects confidence of potential customers and ultimately their buying decisions.
Allowing the more numerous but less profitable customers to wither by neglect, in order to concentrate investment on the less numerous but more profitable ones increases over reliance on a smaller customer base, which increases an organisation’s financial vulnerability. At the same time, concentrating resources on the more profitable customers is likely to result in the law of diminishing returns, where additional investment may only result in a marginal increase in income, but with reduced profitability.
The advantage of thoughtfully applying the 80/20 rule is that it enables the customer base to be evaluated in terms of its overall contribution to profitable income, costs, geographic coverage and market share. As such, those customers which might be deemed less profitable, may well be considered as opportunities for potential growth, rather than seen only as sources of cost and low productivity.
Nicholas Watkis is the founder of Contract Marketing Service, established in 1981. He is a fellow of the Chartered Institute of Marketing and a certified management consultant of the Institute of Business Consultancy. For more articles from Nicholas, click here.