What is the Pareto principle in business and how can I use it to benefit me?
This article is about the ‘Pareto principle,‘ but in particular the ‘Pareto principle in business.’ It is about how the Pareto or 80/20 rule can be used in business management.
The Pareto principle can be used in business to target specific sets of data. The starting point is to analyse your business numbers using the Pareto principle. Once you have the analysed data and where the 80/20 rule applies to the set of data, you’ll be able to make better decisions. For example, have you ever analysed your business revenues? What percentage of your sales comes from which percentage of your customers?
First things first, and for those of you that are not totally familiar with the Pareto principle, a brief explanation is necessary.
The Pareto principle was named after Vilfredo Pareto. Pareto was an Italian economist and engineer amongst other things.
He introduced the concept of Pareto Efficiency. His original studies were into land in Italy. With this study he found that 80% of the land was owned by 20% of the population. However, after this first discovery, it was found that this same 80/20 rule applied in many other places too.
It was discovered that in businesses the income distribution and the reflective work required to earn that income followed the same principles. Which means that in many businesses, 80% of the income is generated by 20% of the clients.
Also, this can be analysed another way, whereby 20% of clients require 80% of the effort to support them.
What is the Pareto principle in business?
I have already explained how the Pareto principle can apply to a business. But this is better explained by way of an example.
A few years ago I had my own Chartered Accounting practice. I came across the Pareto principle and wondered whether it might apply to my business.
I approach it initially not actually knowing what I might do with the information. This was simply because I wasn’t too sure what the outcome might be.
My original thinking was to disbelieve this principle would apply.
I spent some time analysing my numbers in my business.
I then took my total turnover, client by client, and entered this into a spread sheet.
Following this, I then totaled the numbers until I was able to split it between how many client’s ‘total sales‘ represented 80% of my total business revenues.
The results amazed me. Almost to the exact percentage and following the rules of Pareto, this result was staring me in the face.
It turned out that 80% of my revenues were coming from 20% of my clients. The 80/20 rule of Pareto matched exactly. I was shocked. I never though it would work out that way.
It was uncanny, but this now left me thinking about what I wanted to do with the information.
I realised that 80% of my business’s resources were spent on just 20% of my income. And when I tell you we were working quite frantically to keep up with the work. I was working long hours for sure.
As an aside, I actually ended up in the divorce courts, which I largely put down to my working long hours.
Something had to change! I now had the information in front of me from which to help make this change.
How can you use the results from an 80/20 analysis from your business?
Now that I had this information, what do I do with it?
I knew that something had to change, as my life was breaking apart. I would no longer see my daughter every day.
Whilst it was too late to affect and change my person life, I still had a chance to do something about my business.
This is when I put together an Excel template that looks at price increases in business. It looks at the risk of raising prices.
This tool looks at what happens when you raise your prices and looks at how many clients you would need to lose before you would be worse off than before the prices were raised.
It was designed to provide comfort to business owners who struggle with a decision to increase prices.
For me, by having this information where 20% of my income came from 80% of my clients, it was like having gold dust.
I had the view that even if I were to loose all 80% of these clients, all would not be lost.
Yes my income would drop by 20%, but this would free our time up to find more of the type of client that represented the 80% of revenues.
But it would also allow us to be better focused on the 20% of clients too.
In any event, I ran this template on my clients to see how many clients I would have to loose to to be worse off at various price increase percentages.
When I looked at what we were charging for many of the clients that fell into the 80% in numbers, I realised we were under charging them significantly.
In many case, I tripled the charge. Which although seems like a big increase, I did it at the same time as streamlining how the work was done too. We looked at ways of improving the service. This meant that clients got a better service for their increase.
I did have many clients baulked at the increase. I did loose some clients too. But in the end the majority stayed.
This exercise led to increased profits.
These increased profits allowed me to add to the team and helped me to grow my business. I was able to step back from the business and begin to work ‘On’ the business, rather than ‘In’ the business.
How could your business benefit from the Pareto principle?
I hope you have got something from my Pareto example. It’s always better to make decisions based on another person’s case study or real live example.
I urge you to take a look at your business. Run the numbers and analyse your revenues. You may find the same 80/20 rules apply to your business too.
If you need help with your business. If you want help with applying the Pareto 80/20 rule to your business, please complete the contact form.
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