The 80/20 Principle
by Richard Koch, our ActionCLASS Summary
I’d be surprised if you haven’t heard of the 80/20 Principle or what is also called the Pareto Principle, named after the Italian economist Vilfredo Pareto who first noticed the effect.
Most of us know or talk about it in general terms, but have we considered how using it as a true guiding principle can benefit our businesses and ourselves?
In his book, The 80/20 Principle: The secret of achieving more with less, Richard Koch does just that. He tells us by using the principle as a guiding light we can become more successful. If we can spot the few cases where the results relative to the effort are so much greater than usual, we can become so much more efficient in whatever task we want to accomplish.
The 80/20 Overture
What is the 80/20 principle?
In simple terms, the 80/20 principle states that a minority of inputs or effort usually leads to the majority of the results, outputs or rewards. It doesn’t always fall into the 80/20 ratio. It could be 90/10, 75/25, 85/15 or any ratio where general cause and effect are significantly imbalanced.
The observation remained relatively dormant for several years but was resurrected during the quality revolution by Joe Juran who combined the principle with statistical analysis to root our quality faults and improve reliability. Only after the ascendency of Japanese goods did we sit up and take notice. Since then, the principle has influenced all industries: car, computing and consumer goods.
Koch tells us that at the heart of the application of the principle is the process of substitution. If we can replace the 80 percent less effective activities and replace them with more of the 20 percent effective activities, then productivity can increase. If we can focus more of our efforts on the 20 percent of our best customers and less on the 80 percent high maintenance customers, we can in turn increase our profitability.
So why continue to make the 80 percent of products that only generate 20 percent of profits? As managers we rarely ask these questions, perhaps because to answer them would mean very radical action. It would mean to stop doing four-fifths of what we are doing.
Chaos and Tipping
Remember Jeff Goldblum as Ian Malcolm in the blockbuster movie Jurassic Park when he was trying to describe Chaos Theory? We’ll I’m not going to try to do the same, but Koch suggests there is a correlation between Chaos and Pareto, and that is the idea imbalance.
Both theories suggest the world is not linear, and that cause and effect are rarely linked in an equal way. Some forces are always more forceful than others and will try to grab more than their fair share of resources.
The 80/20 Principle aligns to the feedback loops identified by chaos theory, whereby small initial influences can become greatly multiplied and produce highly unexpected results, which can only be explained in retrospect.
Koch suggests there are always a few forces that have an influence way beyond their numbers and these are the forces that we must identify and watch for. If they are forces for good, we should multiply them. If they are forces we don’t like, we need to think very carefully about how to neutralize them.
Also related to the idea of feedback loops is the concept of the tipping point. We’ve all read or have heard of Malcolm Gladwell’s bestselling book, haven’t we? Well using this idea, Koch uses the example of an epidemic to show this might look or work.
The tipping point is the point at which a low-level flu outbreak can turn into a public-health crisis because of the number of people who are infected and can therefore infect others. The principle also applies in reverse where small changes, like bringing new infections down to thirty thousand cases from forty thousand, can have huge effects. That’s Pareto in practice.
On the 80/20 Highway
Koch gives us two concepts to consider: 80/20 Analysis and 80/20 Thinking.
80/20 Analysis examines the relationship between two sets of comparable data. One set of data is always a major sample of people or objects, usually a large number that can be turned into a percentage. The other set of data relates to some interesting characteristics of the people or objects that can be measured and also turned into a percentage.
What is 80/20 Analysis used for?
The 80/20 analysis in practice is used to change the relationship or to make better use of it because that is where the advantage lies. One way to do this is to concentrate on the key causes of the relationship (the 20 percent of inputs that lead to 80 percent of the outputs). You could also do something about the ‘underperforming’ 80 percent of inputs that contribute only 20 percent of the output. The goal here is to focus on the good and make it better, or focus on the weak and make it weaker.
Koch gives a useful example. In US shopping malls it has been found that women account for the greater percentage of the dollar value of all purchases. Simply put women spend more. One way to increase the percentage of sales by men might be to build stores specifically designed for them.
Koch gives us further advice on how we should approach the 80/20 Analysis. He suggests when we use the 80/20 Principle, we should be selective and go against normal thinking. We should not fall into the trap that the variable that everyone else is looking at is what really matters. This is linear thinking. The most valuable insight from the 80/20 Analysis will always come from examining non-linear relationships that others are overlooking (or may not be aware of).
Koch states that if we want the 80/20 Principle to be a guide in our daily lives, we need something less analytical and more instantly available than the 80/20 Analysis. What we need is 80/20 Thinking.
He suggests, 80/20 Thinking requires us to spot the few really important things that are happening and ignore the mass of unimportant things. It teaches us to see the wood for the trees.
To engage in 80/20 Thinking, we need to constantly seek out the 20 percent. We will not always know the answers, but need to engage in some creative thinking to identify the few vital inputs or causes. The idea of 80/20 Thinking is therefore a second phase to the 80/20 Analysis.
When we’ve identified an 80/20 cause we need to decide if it is beneficial to our objectives. Will it help us get better? And, if so how can we increase its impact.
On the other hand, if it’s not beneficial to our objective, we need to identify how we can frustrate its development. Koch suggests we focus. We do not need to look at being good at everything, but to be exceptional at fewer things. Like the principle itself, we should concentrate on a few areas, which can increase greater benefit from outperforming others.
Koch gives us a few immediate pointers to apply the 80/20 Principle to our businesses.
1. Think small
Don’t plan to the nth degree. The return on investment usually follows this 80/20 rule: 80 percent of the benefits will be found in the simplest 20 percent of the system. This is especially true for software, where 80 percent of a product’s uses take advantage of only 20 percent of its capabilities. This means most of us to pay for what we don’t want or need.
2. Segment and Focus
In any market, some suppliers will be much better than others at satisfying customer needs. Over time, 80 percent of the market will tend to be supplied by this 20 percent or fewer of the suppliers – most of whom will also normally be more profitable. To get a share, we need to divide the market up into segments and identify which segments are in the 20 percent. If we are in too many segments, we need to get out of those that fall within the 80 percent or we need to analyze profitability to focus only on those where the 80/20 principle applies.
3. Make a Killing
If you can identify where you’re getting back more than putting in, you can up the stakes and make a killing. Similarly, if you can work out where you’re getting back much less than 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 even an employee, type of employee or team.
Koch claims unless we have used the 80/20 Principle to redirect our strategy, the strategy is badly flawed. We don’t have an accurate picture and almost inevitably we are doing too many things for too many people. He suggests we need to identify which parts of the business are profitable, which are just breaking even and which are disasters. To this, we need to conduct an 80/20 Analysis of profits by different categories of business such as product or product group/type or by customer or customer group for example.
In the book, Koch provides a series of challenging investigations and asks the following questions:
- 80 percent of the profits made in any industry are made by 20 percent of firms. If you aren’t one of these, what are they doing right that you’re not?
- 80 percent of the benefit from any product or service can be provided at 20 percent of the cost. Many consumers would buy a stripped-down, very cheap product. Is anyone providing it in your industry?
- 80 percent of any industry’s profits come from 20 percent of its customers. Do you have a disproportionate share of these? If not, what would you need to do to get it?
When we’ve done the 80/20 Analysis of the above, Koch says only then can we set our 80/20 strategy that focuses on the 80/20 Principle.
Here is Koch’s hypothesis:
Simple is beautiful but businesspeople love complexity. No sooner is a simple business successful than its managers pour vast amounts of energy into scaling it up. This in turn makes it much more complicated. Yet, additional scale is rarely just more of the same. Even if the customer is the same, the extra volume usually comes from adapting an existing product, providing a new product or adding more service.
When business is simple, the chances are that it is closer to the customer. There is less management in the way. Customers can be heard, feel they are important and are willing to pay a lot more for this.
So how can we scale at the 80/20 levels?
Koch suggests the following:
We should let go of the less profitable customers and products, cut off most support and sales efforts, raise prices and allow sales to decline at 5-20 percent. By doing so, we can bring simplicity and profitability back. Why do this you ask? Simply because difficult customers demand more resources.
Become customer-centred for the few right customers. Successful marketing is all about a focus on the relatively small number of customers who are the most active in consuming your product or service. Focusing on 20 percent of your customers is a great deal easier than focusing on 100 percent of them. Focusing on all of your customers is an impossible undertaking, so why not choose to focus your time, energy and resources on those who positively impact your bottom line?
Koch gives us four steps to lock in our core customers:
- Step 1: Identify who the 20 percent are;
- Step 2: Provide exceptional service;
- Step 3: Target new products and service solely at them; and
- Step 4: Keep them forever.
80/20 Decision making
Koch suggests we can make critical decisions in alignment with the 80/20 principle. We are going to apply it pervasively so decision making is no exception.
Rule #1: Not all decisions are very important. Using the 80/20 split we should avoid agonizing over the unimportant decisions, and above all don’t conduct expensive and time-consuming analyses. If it is unimportant and has a 51 percent probability of success – go for it!
Rule #2: The most important decisions are often those made by default because the chance to influence has passed. When this happens, no amount of data gathering and analysis will help you realize the problem or opportunity. What you need is intuition and insight – to ask the right questions rather than getting the right answers to the wrong questions.
Rule #3: For a critical decision, gather 80 percent of the data and perform 80 percent of the relevant analyses in the first 20 percent of the time available and then make an assertive decision with 100 percent confidence. Generally, you won’t be wrong.
Rule #4: Simply, if what you have decided isn’t working, change your mind earlier rather than later.
Rule #5: When something is working well, double and redouble your effort. You may not know why it’s working so well but push as hard as you can while the force is with you.
That’s it. This summary covers 20 percent of the value of the book, but there is another 80 percent of the benefit to accrue if you spend 20 percent of your free time reading it. Pareto promises!
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