Business
80/20: The Business
Part 2 of the 80/20 series focusses on corporate success.
80/20: The Business
Part 2 of the 80/20 series focusses on corporate success — where a business is actually making money, and why the honest answer is almost never the one on the revenue report.
Strategy & Profitability
The first question: Where are you actually making money?
The problem with most business reporting: Most businesses are focussed on billings, GMV, revenues, and the like. To understand your business, you must stop looking at revenue and start looking at profitability by segment. The results are rarely what you expect.
The problem with standard accounting: Standard cost systems make it near impossible to know true product profitability. They often allocate overheads to business segments on a crude basis (e.g., percentage of revenue), hiding the true cost of certain high-maintenance products or services.
The 80/20 Diagnosis
Identify your segments: The first step is to identify your business segments. A competitive segment is a part of your business where you face a different competitor or different competitive dynamics. Take any part of your business that comes to mind — a product, a customer, a product line sold to a customer type, or any other split that matters to you (consultants, for example, may think of M&A work). Now ask yourself two simple questions:
- Do you face a different main competitor in this part of your business compared to the rest of it? If yes, then that part of the business is a separate competitive segment.
- Do you and your competitor have the same ratio of sales or market share across the two areas, or is one of you relatively stronger in one area and weaker in another?
Understand true profitability: Allocate all the overhead costs to each product group on some reasonable basis. The crudest way is to allocate on a percentage of revenues — but a moment’s thought should convince you this will not be accurate. Some products take a great deal of salespeople’s time relative to their value; 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 on as accurate a basis as possible. Do this for all the costs, then look at the results.
80/20 Actions: Profits can be raised dramatically by concentrating on the market and customer segments that are already the most profitable, and expanding them. The most profitable segments will tend to be — though not always — where the firm enjoys the highest market shares, and where it has the most loyal customers (loyalty being defined by being longstanding and least likely to defect).
Four segments deliver almost all the profit on about a third of the sales.
Each business segment’s share of sales (left) and share of profits (right), in %; loss-making segments extend left of the zero line. Source: Richard Koch, The 80/20 Principle (illustrative).
Identify segments
Split your business into competitive segments. A segment is any part of your business — a product, a customer type — where you face a different main competitor or different competitive dynamics.
Allocate all costs
Go beyond gross margin. Allocate every overhead cost — sales time, advertising, manufacturing complexity, R&D, administrative fuss — to each segment.
Visualise the truth
You will inevitably find that 80% of your profits come from 20% of your segments. The rest are marginal, or actively losing you money.
Case Study: 80/20 analysis applied to a consulting firm
A strategy consulting firm with USD 170m of sales performed an 80/20 analysis. They segmented their business three ways.
Large v small projects
| Business split | Sales ($000) | Profits ($000) | Return on sales |
|---|---|---|---|
| Large projects | 35,000 (21%) | 16,000 (56%) | 45.7% |
| Small projects | 135,000 (79%) | 12,825 (44%) | 9.5% |
| Total | 170,000 | 28,825 | 17.0% |
Old v new clients — the hidden value of loyalty
| Business split | Sales ($000) | Profits ($000) | Return on sales |
|---|---|---|---|
| Old clients (>3 yrs) | 43,500 (26%) | 24,055 (83%) | 55.3% |
| Intermediate clients | 101,000 (59%) | 12,726 (44%) | 12.6% |
| New clients (<6 mos) | 25,500 (15%) | (7,956) (−28%) | −31.2% |
| Total | 170,000 | 28,825 | 17.0% |
By project type
| Business split | Sales ($000) | Profits ($000) | Return on sales |
|---|---|---|---|
| M&A | 37,600 | 25,190 | 67.0% |
| Strategic analysis | 75,800 | 1,600 | 2.1% |
| Operational projects | 56,600 | 2,035 | 3.6% |
| Total | 170,000 | 28,825 | 17.0% |
Profitability isn’t enough. Is it a good business?
An 80/20 analysis tells you where you are making money. A further strategy overlay tells you where you should be placing your bets for the future.
| Segment | Market attractive? | Firm well positioned? | Profitability |
|---|---|---|---|
| 1 | Yes | Yes | Very high |
| 2 | Yes | Yes | Very high |
| 3 | Yes | Yes | Very high |
| 4 | Yes | Yes | Very high |
| 5 | Yes | Yes | High |
| 6 | Yes | Yes | High |
| 7 | Yes | Moderately | High |
| 8 | Yes | Moderately | Fairly high |
| 9 | Yes | No | OK |
| 10 | Not very | Yes | OK |
| 11 | Not very | Yes | OK |
| 12 | No | Moderately | Poor |
| 13 | Yes | Improving | Loss making |
| 14 | No | Moderately | Loss making |
| 15 | No | No | Loss making |
After identifying your profitable segments, ask two further questions:
Is the segment an attractive market to be in? — growth, barriers to entry, bargaining power versus customers and suppliers.
How well is our firm positioned in that segment? — market share, unique capabilities, competitive strength.
Take action: a strategy for every segment
The goal of 80/20 strategy is to stop treating all parts of the business equally. Align resources with potential — starving the losers to hyper-focus on the winners.
| Priority | Characteristics | Action |
|---|---|---|
| A | Attractive markets, high profitability, good share | Heavy management focus, raise sales effort |
| B | Attractive markets, good profitability, moderate position | Hold position, no special initiatives |
| C | Unattractive / poor share | Harvest (lower costs, raise prices) or less effort |
| A (subscale) | Attractive market, improving position, loss making | Gain share quickly (invest to win) |
| Z | Unattractive markets, poor position, loss making | Sell / close |
Simple is beautiful. Complex is ugly.
Executives love complexity. Once a business is successful, they cannot resist complicating it with marginal products, new customers, and layers of management. Complexity automatically makes a company less profitable. It reduces focus on what is simple and profitable.
Simple
To make a company more profitable, make it simpler — then scale the new, highly profitable business to the maximum. Small is not beautiful; simple and big is beautiful. Progress requires simplicity, simplicity requires ruthlessness, and that is why simple is as rare as it is beautiful.
Complex
There is a natural tendency for business, like life, to become overcomplex. All organisations — especially large ones — are inherently inefficient and wasteful. They should be adding value to customers; any activity that does not is unproductive.
Every person and every organisation is the product of a coalition, and the forces within the coalition are always at war. The war is between the trivial many and the vital few. The trivial many are the prevalent inertia and ineffectiveness. The vital few are the breakthrough streaks of effectiveness, brilliance and good fit. Most activity results in little value and little change; a few powerful interventions have massive impact. The war is difficult to observe: it is the same person, the same unit and the same organisation which produces both a mass of weak (or negative) output and a smattering of highly valuable output.
Once made more complex, a company automatically becomes less profitable. Complexity leads to taking on more marginal business and reduces the focus on what is simple and profitable.
The lamest excuse in business
But we need the volume to cover overheads.
When confronted with 80/20 data, managers often argue that unprofitable segments “contribute to overheads”. This sounds reasonable. It is not.
The unprofitable 80% is unprofitable precisely because it requires overhead. The overhead exists to support complexity. Remove the complexity and the overhead can disappear with it.
The profitable 20%, by contrast, often requires very little central support. It is profitable because it is simple — and because it has been left alone. What looks like shared cost is usually self-inflicted cost.
Added complexity pushes unit cost above the level simplicity would reach.
Illustrative unit-cost curves plotted against volume / market share — the actual industry curve and the lower curve achievable with simplicity; the shaded band is the hidden cost. Source: Richard Koch, The 80/20 Principle.
Managers assume
“If we remove revenue, overhead remains.”
The reality
“If we remove complexity, overhead collapses.”
Unprofitable segments do not merely fail to cover overheads. They cause them.
The Simplicity Playbook
Progress requires simplicity. Simplicity requires ruthlessness. This is why simple is rare — and why it wins.
Dismantle the hierarchy
If you are just in one line of business, you don’t need a head office, regional head offices or functional offices. The abolition of the head office can have an electric effect on profits.
The key problem with head offices is not their cost. It is the way they take away real responsibility and initiative from those who do the work and add the value to customers. Corporations should centre themselves around customer needs rather than around the management hierarchy.
In almost every 80/20 exercise, the most profitable parts of the business are those with the least central interference. This is not an accident.
Outsource everything but your genius
Most cost programmes fail because they preserve the shape of the business. They shave budgets while leaving complexity intact.
Outsourcing is a terrific way to cut complexity and costs. Decide which part of the value-adding chain (R&D–manufacturing–distribution–selling–marketing–servicing) your company has the greatest comparative advantage in, and then ruthlessly outsource everything else. This takes out most of the costs of complexity, enables dramatic reductions in headcount, and speeds up your time to market. The result: much lower costs and often significantly higher prices too.
When low-volume, unprofitable products are eliminated, capacity frees up, overhead shrinks naturally, and profitability rises without heroics.
Rethink management incentives
Managers tend to like complexity: complexity increases span of control, and span of control increases status. That newfound status then resists simplification.
Complexity is also interesting and rewarding to managers — particularly those who are smart but wholly focussed on administration rather than sales or operations. This produces an administrative hierarchy that manufactures complexity, tolerated long after it stops being affordable.
Unless an organisation faces crisis — or has an unusually customer- and investor-oriented leader, or the right incentives in place — complexity is almost guaranteed to grow.
Radically focus the business
Go for the 20%. Concentrate on providing a stunning product and service to the 20% of customers who provide 80% of your profits.
Cut the number of products, customers, and suppliers to focus only on the most profitable. Standardise delivery of these products or services on as universal and global a basis as possible. Pass up thrills, bells and whistles. Make the profitable 20 percent as high quality and consistent as imaginable.
Whenever something has become complex, simplify it; if you cannot, eliminate it. This is essentially Elon Musk’s key tool for success.
The principle in action: the Japanese Quality Revolution
The story
In the 1950s, the work of pioneers like Joseph Juran was largely ignored in the West. Japan, then known for shoddy goods, embraced their ideas.
The 80/20 application
Juran focused on the “vital few” causes that led to the majority of quality defects. By addressing this critical 20% of problems, Japanese manufacturers achieved an unprecedented leap in quality and productivity.
“For every step in your business process, ask yourself if it adds value or provides essential support. If it does neither, it’s waste. Cut it.”
The 80/20 Marketing Gospel
Focus on the small majority of markets and customers that are most profitable and enjoyable to serve, and have the highest growth potential. Provide a stunning product and service to this 20 percent. The three golden rules are:
Be marketing-led for the few right product and marketing segments. Be customer-centred for the few right customers. Channel effort where you offer something unique, or much better value than peers.
Salesperson performance
Sales is marketing’s close cousin: the front-line activity to communicate and — at least as importantly — to listen to customers. Take any salesforce and perform an 80/20 analysis, and it is odds-on you will find an unbalanced relationship between sales and salespeople. Steps to re-engineer your salesforce for maximum impact:
Hang on to your high performers
Keep them happy. This cannot be done mainly with cash.
Hire more of the same type
Personality and attitude probably matter more than qualifications. Put your sales superstars in a room and work out what they have in common — better still, ask them to help you hire more people like them.
Find when the best sell most
80/20 applies to time as well as people. Identify when your top salespeople sold the most, and what they were doing differently during a hot streak.
Copy the highest-yield methods
Get everyone to adopt whatever has the highest ratio of output to input — advertising, networking, proactive tailored messaging, consistency, or simply making the calls.
Swap winning and losing teams
Switch a successful team from one area with an unsuccessful team from another. This tells you whether the good team can beat structural differences — and vice versa.
Train the lower 80%
Invest in training the lower 80% — but only those you are sure plan to stick around, and have your best salespeople do the training, rewarded on the subsequent performance of their trainees.
Making structural sales changes
A great deal of sales depends on the quality of the products being sold, and the customers and markets being served. Those in charge of salesforces should:
5 rules for decision taking with 80/20
Business requires decisions — frequent, fast, and made without much idea whether they are right or wrong.
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1 Not many decisions are very important
Before deciding anything, picture two trays in front of you — one marked Important Decisions, one Unimportant Decisions. Sort mentally, remembering that only one in five is likely to fall into the important box.
Do not agonise over the unimportant decisions and, above all, don’t conduct expensive, time-consuming analysis. Delegate them if you can. If you can decide which option has a 51 percent chance of being right, decide. If you can’t decide that quickly, spin a coin.
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2 The most important decisions are often made only by default
Turning points come and go without being recognised. Your chief money-makers leave because you weren’t close enough to notice their disaffection. A competitor develops a product you think is wrongly conceived. You lose a leading share position without realising it as the channels of distribution change. Or the nerd working with you in R&D ups and founds Amazon.
No amount of data-gathering will help you see it. What you need is intuition and insight — to ask the right questions rather than getting the right answers to the wrong ones. The only way to stand a chance of noticing critical turning points is to stand above all your data for one day a month and ask: what uncharted problems and opportunities are mounting up without my noticing? What is working well when it shouldn’t? Is something going badly astray where I think I know why, but might be totally wrong?
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3 80/20 the 80/20 analysis
For important decisions, gather 80 percent of the data and perform 80 percent of the relevant analyses in the first 20 percent of the time available — then make a decision and act decisively, as if you were 100 percent confident it was right.
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4 Don’t be afraid to experiment or change your mind
If what you have decided isn’t working, change your mind early rather than late. The market — what works in practice — is a far more reliable indicator than tons of analysis. So experiment, don’t persevere with losing solutions, and do not fight the market.
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5 Double down on winners
When something is working well, double and redouble your bets. You may not know why it’s working so well, but push as hard as you can while the forces of the universe are bending your way.
80/20 project management
Many of the most energetic people in business, from the CEO down, do not really have a job: they pursue a number of projects.
Project management is an odd task. A project involves a team — a cooperative, not a hierarchical arrangement — yet team members usually do not fully know what to do, because the project requires innovation and ad hoc arrangements. The art of the project manager is to focus everyone on the few things that really matter.
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Simplify the objectives
A project is almost never one project — it is several. Strip it down until it has one simple aim. Projects obey the law of organisational complexity: the greater the number of aims, the effort required rises not in proportion but geometrically. 80 percent of the value comes from 20 percent of the activities; the rest is needless complexity.
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Impose an impossible time scale
Faced with an impossible deadline, the team will identify and implement the 20 percent of the requirement that delivers 80 percent of the benefit. It is the ‘nice to have’ features that turn sound projects into catastrophes. Impose stretch targets — ask for a prototype in four weeks, a live pilot in three months. Desperate situations inspire creative solutions.
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Plan before you act
The shorter the time allowed, the greater the proportion of it that should go to planning and thinking through. The best-managed projects are those with the greatest ratio of planning time to execution time. Write down every critical issue; if there are more than seven, drop the least important. Construct hypotheses — even guesses — decide who does what and when, then replan after short intervals as you learn.
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Design before you implement
If the project involves designing a product or service, secure the best possible answer in the design phase before implementation. 20 percent of the problems cause 80 percent of the costs and overruns — and 80 percent of those critical problems arise in design, where they are cheap to fix and hugely expensive to correct later.