“The way is long if one follows precepts, but short… if one follows patterns.” – Lucius Annaeus Seneca
The Pareto Principle, Part II:
A Universal Law That Even Applies to Business
The Pareto Principle would be a significant contribution to learning if it applied only to economics. But as I said in Part I of this series, it applies to just about everything. Whenever and wherever you measure resources or the relationship between cause and effect, you’ll find this lopsided distribution.
A few examples:
* 80% of taxes are collected from 20% of taxpayers.
* 80% of government spending goes to 20% of its expenditures.
* 80% of new technology is patented by 20% of technology companies.
* 80% of the drugs approved each year are made by 20% of the research labs.
* 20% of criminals commit 80% of all crimes.
* 20% of drivers cause 80% of all traffic accidents.
* 20% of factories produce 80% of the pollution.
* Through the 2015-2016 NBA season, 20% of franchises won 75.3% of the championships.
I could go on, but you get the point. Economics. Science. Human behavior. Sports. In playing with his pea plants, Vilfredo Pareto seems to have discovered some sort of universal pattern.
We’ll look into the philosophical implications of this on Friday in Part III. Today, let’s take a look at how the Pareto Principle applies to something very practical. Let’s talk about business.
Understanding business through the 80/20 lens
I don’t remember exactly when I first read about the Pareto Principle, but I’m certain I did not grok it early in my career. It wasn’t until I was running a multimillion-dollar company in which I had secured a profit share… and there’s a good reason for that. There’s something about aligning one’s interests with those of the business that makes such insights invaluable. It is immensely helpful in analyzing problems, understanding challenges, and making important decisions.
Since then, I’ve written about the 80/20 rule many times. And now that I think about it, I can say that the Pareto perspective was responsible for all of my bestselling business books, including Automatic Wealth and Ready, Fire, Aim.
There are so many examples of how the Pareto Principle applies to business:
* 20% of a company’s salesmen produce about 80% of its sales.
* 20% of a company’s customers/clients account for 80% of the purchases made.
* 80% of all customer complaints come from 20% of the customer base.
* 80% of customer complaints are related to 20% of the company’s products.
I could list hundreds.
But there are three categories that stand out:
- The 80/20 rule in product development
If you look at almost any business, you will find that about 80% of its revenues come from only 20% of the products sold.
This seems obvious to me now. It’s almost a bromide. But it was a revelation when I first figured it out.
At the time, we had about 20 product lines and were doing about $20 million in revenues, with average revenues of $1 million per product. I was well aware that some products performed much better than others. But until I looked at our sales from the Pareto perspective, I didn’t realize how lopsided the distribution was.
Sixteen of our products generated sales of $5 million. They averaged just $312,500 each. The rest of our sales – $15 million worth – came from just 4 products. An average of just under $4 million each.
The imbalance was much more extreme than I would have guessed. But it allowed me to understand, instantly, that my habit of giving equal attention to all of our products was a big mistake.
The cost of producing and marketing each product was about the same, but the revenues were so terribly uneven. It was easy to see that we were basically losing money on 80% of our products and making huge profits on just 20% of them.
If profits were the lifeblood of a business (and they are), why was I not giving 80% of my time and attention to the 20% that would yield 80% of our profits?
We had ben dividing our marketing resources equally among the products we were selling. After understanding the Pareto Principle, we directed 80% of those resources to the top three or four. That resulted in a much faster-growing customer base, and, subsequently, higher revenues and profits.
- The 80/20 rule in customer spending
After learning that lesson, I began to apply it to every other aspect of our business. One challenge had been the issue of customer lifetime value.
In our industry (information publishing), we measured our long-term success by renewals. The average first-year renewal rate was about 20%. It was generally accepted that if you could raise it by increments – to about 50% in the second year and 60% thereafter – you could grow the business.
Then one day I met a man named Jay Abraham who had a crazy idea he was peddling about what he called “the back end.” The idea was that instead of trying to boost our renewal rate by increments, we could do much better by immediately selling existing customers more expensive versions of what they had already bought. If, for example, they had spent $39 for a newsletter on executive productivity, we could sell them a special report “on the backend” written by an expert on the same topic for, say, $79.
I got it instantly, because I was thinking in terms of 80/20. I was pretty sure that 80% of our existing subscribers would never buy a more expensive back-end product, but that 20% of them would. And the first test we did – selling an information product for hundreds of dollars – more than verified that. It blew us away! (Today, the same sorts of back-end information products often sell for thousands.)
- The 80/20 rule and the people you depend on to make your business grow
Those two applications of the Pareto Principle made me a better at developing products and marketing them. But I’m most excited about a realization that came late in my career.
I was thinking about the writers, editors, publishers, copywriters, and marketers I had worked with, and it occurred to me that Pareto’s Principle applied to them as well: A relatively small percentage – maybe 20% – had been responsible for the great majority of the business success I had witnessed.
I should qualify that. Building a business is a collaborative effort. Dozens or hundreds of people are involved in getting the work done.
But it would be naïve to pretend that everyone is equally responsible for its success. There is always a small number that stand out clearly. They work harder. They think harder. They never run away from a problem. They never hide a mistake. They treat your business as if they owned it. In the skyscape of any company’s employees, they shine where the best of the others only glow.
Although money matters to them, these superstars are not motivated by it. Nor are they motivated by the desire for approval. They are unique. They are rare. And they are worth their weight in gold.
Based on my observations, if you are very lucky, 20% of your employees will be superstars.
Something to seriously consider.
I’ve heard it said that the Pareto Principle is the best-kept secret in business. That’s difficult to believe if you are familiar with business literature. There are literally thousands of articles, essays, and manuals written about it every year.
So, no, it’s not the best-kept secret in business. But it is routinely ignored. I’m not sure why that is, but I do know this: If you pay attention to the Pareto Principle in your business, you will be glad you did.
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