The 80/20 Principle: The Secret of Achieving More With Less (9 page)

• At the lowest level of aggregation of resources within the firm, for example an individual employee, 80 percent of the value created is likely to be generated in a small part, approximately 20 percent, of the time when, through a combination of circumstances including personal characteristics and the exact nature of the task, the employee is operating at several times his or her normal level of effectiveness.

• The principles of unequal effort and return therefore operate at all levels of business: markets, market segments, products, customers, departments, and employees. It is this lack of balance, rather than a notional equilibrium, that characterizes all economic activity. Apparently small differences create large consequences. A product has to be only 10 percent better value than that of a competing product to generate a sales difference of 50 percent and a profit difference of 100 percent.

Three action implications

One implication of the 80/20 theory of firms is that successful firms operate in markets where it is possible for that firm to generate the highest revenues with the least effort. This will be true both absolutely, that is, relative to monetary profits, and relatively, that is, in relation to competition. A firm cannot be judged successful unless it has a high absolute surplus (in traditional terms, a high return on investment) and also a higher surplus than its competitors (higher margins).

A second practical implication for all firms is that it is always possible to raise the economic surplus, usually by a large degree, by focusing only on those market and customer segments where the largest surpluses are currently being generated. This will always imply redeployment of resources into the most surplus-generating segments and will normally also imply a reduction in the total level of resource and expenditure (in plain words, fewer employees and other costs).

Firms rarely reach the highest level of surplus that they could attain, or anywhere near it, both because managers are often not aware of the potential for surplus and because they often prefer to run large firms rather than exceptionally profitable ones.

A third corollary is that it is possible for every corporation to raise the level of surplus by reducing the inequality of output and reward within the firm. This can be done by identifying the parts of the firm (people, factories, sales offices, overhead units, countries) that generate the highest surpluses and reinforcing these, giving them more power and resources; and, conversely, identifying the resources generating low or negative surpluses, facilitating dramatic improvements and, if these are not forthcoming, stopping the expenditure on these resources.

These principles constitute a useful 80/20 theory of the firm, but they must not be interpreted too rigidly or deterministically. The principles work because they are a reflection of relationships in nature, which are an intricate mixture of order and disorder, of regularity and irregularity.

LOOK FOR “IRREGULAR” INSIGHTS FROM THE 80/20 PRINCIPLE

It is important to try to grasp the fluidity and force driving 80/20 relationships. Unless you appreciate this, you will interpret the 80/20 Principle too rigidly and fail to exploit its full potential.

The world is full of small causes that, when combined, can have momentous consequences. Think of a saucepan of milk that when heated above a certain temperature suddenly changes form, swelling up and bubbling over. One moment you have a nice, orderly pan of hot milk; the next moment you can either have a wonderful cappuccino or, if you are a second too late, a mess on top of your stove. Things take a little more time in business, but one year you can have an excellent and very profitable IBM dominating the computer industry and, before long, a combination of small causes results in a blinded monolith staggering to avoid destruction.

Creative systems operate away from equilibrium. Cause and effect, input and output, operate in a nonlinear way. You do not usually get back what you put in; you may sometimes get very much less and sometimes get very much more. Major alterations in a business system can flow from apparently insignificant causes. At any one time, people of equal intelligence, skill, and dedication can produce quite unequal results, as a result of small structural differences. Events cannot be predicted, although predictable patterns tend to recur.

Identify lucky streaks

Control is therefore impossible. But it is possible to influence events, and, perhaps even more important, it is possible to detect irregularities and benefit from them. The art of using the 80/20 Principle is to identify which way the grain of reality is currently running and to exploit that as much as possible.

Imagine you are in a crazy casino, full of unbalanced roulette wheels. All numbers pay odds of 35 to 1, but individual numbers come up more or less frequently at different tables. At one, number five comes up one time in twenty, at another table it only comes up one time in fifty. If you back the right number at the right table, you can make a fortune. If you stubbornly keep backing number five at a table where it comes up one time in fifty, your money will all disappear, regardless of how high your starting bank.

If you can identify where your firm is getting back more than it is putting in, you can up the stakes and make a killing. Similarly, if you can work out where your firm is getting back much less than it is investing, you can cut your losses.

In this context, the “where” can be anything. It can be a product, a market, a customer or type of customer, a technology, a channel of distribution, a department or division, a country, a type of transaction or an employee, type of employee or team. The game is to spot the few places where you are making great surpluses and to maximize them and to identify the places where you are losing and get out.

We have been trained to think in terms of cause and effect, of regular relationships, of average levels of return, of perfect competition, and of predictable outcomes. This is not the real world. The real world comprises a mass of influences, where cause and effect are blurred, and where complex feedback loops distort inputs; where equilibrium is fleeting and often illusory; where there are patterns of repeated but irregular performance; where firms never compete head to head and prosper by differentiation; and where a few favored souls are able to corner the market for high returns.

Viewed in this light, large firms are incredibly complex and constantly changing coalitions of forces, some of which are going with the grain of nature and making a fortune, while others are going against the grain and stacking up huge losses. All this is obscured by our inability to disentangle reality and by the calming, averaging (and highly distorting) effects of accounting systems. The 80/20 Principle is rampant but largely unobserved. What we are generally allowed to see in business is the net effect of what happens, which is by no means the whole picture. Beneath the surface there are warring positive and negative inputs that combine to produce the effect we can observe above the surface. The 80/20 Principle is most useful when we can identify all the forces beneath the surface so that we can stop the negative influences and give maximum power to the most productive forces.

HOW COMPANIES CAN USE THE 80/20 PRINCIPLE TO RAISE PROFITS

Enough of history, philosophy, and theory! We now switch gears to the intensely practical. Any individual business can gain immensely through practical application of the 80/20 Principle. It is time to show you how.

Chapters 4 to 7 cover the most important ways to raise profits via the 80/20 Principle. Chapter 8 closes Part Two with hints on how to embed 80/20 Thinking into your business life so that you can gain an unfair advantage over colleagues and competitors alike.

We start in the next chapter with the most important use of the 80/20 Principle in any firm: to isolate where you are really making the profits and, just as important, where you are really losing money. Every business person thinks they know this already, and nearly all are wrong. If they had the right picture, their whole business would be transformed.

4

WHY YOUR STRATEGY IS WRONG

Unless you have used the 80/20 Principle to redirect your strategy, you can be pretty sure that the strategy is badly flawed. Almost certainly, you don’t have an accurate picture of where you make, and lose, the most money. It is almost inevitable that you are doing too many things for too many people.

Business strategy should not be a grand and sweeping overview. It should be more like an underview, a peek beneath the covers to look in great detail at what is going on. To arrive at a useful business strategy, you need to look carefully at the different chunks of your business, particularly at their profitability and cash generation.

Unless your firm is very small and simple, it is almost certainly true that
you make at least 80 percent of your profits and cash in 20 percent of your activity, and in 20 percent of your revenues.
The trick is to work out
which
20 percent.

WHERE ARE YOU MAKING THE MOST MONEY?

Identify which parts of the business are making very high returns, which are just about washing their faces, and which are disasters. To do this we will conduct an 80/20 Analysis of profits by different categories of business:

• by product or product group/type

• by customer or customer group/type

• by any other split which appears to be relevant for your business for which you have data; for example, by geographical area or distribution channel

• by competitive segment.

Start with
products.
Your business will almost certainly have information by product or product group. For each, look at the sales over the last period, month, quarter, or year (decide which is most reliable) and work out the profitability after allocating all costs.

How easy or difficult this will be depends on the state of your management information. What you need may all be readily available, but if not you will have to build it up yourself. You are bound to have sales by product or product line and almost certainly the gross margin (sales less cost of sales). You will also know the total costs for the whole business (all the overhead costs). What you then have to do is to allocate all the overhead costs to each product group on some reasonable basis.

The crudest way is to allocate costs on a percentage of turnover. A moment’s thought, however, should convince you that this will not be very accurate. Some products take a great deal of salespeople’s time relative to their value, for example, and others take very little. Some are heavily advertised and others not at all. Some require a lot of fussing around in manufacturing whereas others are straightforward.

Take each category of overhead cost and allocate it to each product group. Do this for all the costs, then look at the results.

Typically some products, representing a minority of turnover, are very profitable; most products are modestly or marginally profitable; and some are really making large losses once you allocate all the costs.

Figure 10 shows the numbers for a recent study I conducted of an electronic instrumentation group. Figure 11 gives the same data visually; look at this if you prefer pictures to numbers.

Figure 10 Electronic Instruments Inc. sales and profits table by product group

We can see from the two figures that Product group A accounts for only 3 percent of sales, but for 10 percent of profits. Product groups A, B, and C account for 20 percent of sales, but for 53 percent of profits. This becomes very clear if we compile an 80/20 Table or an 80/20 Chart, as in Figures 12 and 13 respectively.