Business Survival Series: Pareto Principle

When your business is under the pump if your competitor doesn’t deliver the final blow, your own inaction will. Inertia is the enemy of a struggling business. You must act quickly in order to enact meaningful change. But what’s the right move? 

Embracing the Pareto Principle could be your first step for choosing what to focus on.

What is the Pareto Principle?

This is the 80/20 rule. 

The Pareto Principle, named after Italian philosopher and economist Vilfredo Federico Damaso Pareto, outlines that 80% of results come from 20% of actions. Pareto formulated the Principle after observing that 80% of the land in Italy was owned by 20% of the population. He then investigated a number of other industries and nations and found that the Principle applied across the board. Thus, the creation of the Pareto Principle.

The Pareto Principle is reflected in a number of scenarios. For example:

• 20% of patients account for 80% of healthcare spending.
• 20% of drivers cause 80% of traffic accidents.
• 80% of pollution originates from 20% of factories.
• 80% of software problems are caused by 20% of bugs.

The Principle is similarly likely reflected in your own business. For example:

• 20% of your company’s sales representatives likely generate 80% of your total sales.
• 20% of your company’s customers likely account for 80% of your total profits.
• 80% of complaints made against your company likely come from 20% of your customers.
• 80% of your personal work outputs is likely conducted within only 20% of your time at work. 

The Principle essentially describes the unequal relationship between inputs and outputs. Whilst the balance may not always be exactly 80% to 20%, for the most part it is a generalisation that is appropriate for describing most situations. 

If you look at it another way, a business owner should focus their efforts on the important few issues in any turnaround.

How can you implement the Pareto Principle to help your business?

First conduct a Pareto analysis of your business including all products and service offerings. You will most likely find that the Principle applies to your business, meaning 80% of your revenue is coming from 20% of your customers or product lines. This will help you identify where the issues lie. As outlined by Domenic Aversa in Corporate Undertaker:

‘Once you have that, dig into those numbers and discover where the best margins are – focus on building those segments. Oftentimes, troubled companies’ top sellers are margin losers – which is one of the main reasons they are in trouble. They mistake revenue for profits. Their salespeople were beating their competitors because their product or service was underpriced. Sometimes, to survive, you have to dump your best seller (if you can’t figure out how to make it more profitable).’

With that information in hand, act fast. Get rid of the products and retrench the employees for which the margins are too small. Once you have cleaned house focus your time, energy and money on the products or services with the highest margins. Those products or services with the best contribution margins will yield the best outcomes for your business. 

Liquidate your unproductive assets. Eliminating unproductive elements of your business is vital. Instead focus on the most important projects and your most valuable employees.

Don’t diversify just for the sake of diversifying. Of course, putting all your time and energy into one spot will not be beneficial for your business. But it’s important to consolidate relationships before expanding. Focus on your best clients and strengthen those relationships before spreading yourself and your business too thin. 

In a turnaround scenario it may be better to downsize and focus. It is very unlikely that hiring, adding product lines or new processes would be prudent.

The lesson to be learnt

Acting swiftly and effectively under pressure can be tough. Using widely accepted principles such as Pareto can help you focus your energy on what’s important and strengthen your chances of making positive change within your business. Don’t wait for solutions to come to you, get on the front foot and take action to help your business add value to the most important areas.