The Pareto principle is one of those universal rules of business that has far-reaching implications for today's enterprises. It can help companies mitigate risk by allowing them to identify potentially dangerous outcomes of existing strategies. The focus is simple: Be proactive instead of reactive. The rule originated in 1906 from Vilfredo Pareto, an Italian economist who found that 80 percent of land in Italy was owned by 20 percent of its population. How does this apply to businesses?
Sales and Revenue: The 80-20 rule states that 80 percent of a company’s sales come from the top 20 percent of its customers. In some cases it’s 10 percent, and in the worst of cases it’s one, two or three customers that account for 80 percent of a company’s sales.
All of this can go on for years. Companies can spend all their resources and time catering to these two or three customers. The more they focus on these two customers, the further they remove themselves from the other customers their market. The less they know about their market, the less they are able to capitalize on sales.
Imagine the impact to your business if you were to lose your two biggest customers. If you had spent years catering to these customers, how would you then go back to the rest of your customer base if they knew nothing about you? This has happened to a number of companies since the most recent global financial crisis of 2008. Companies have suddenly woke up to a new reality: They’ve lost their biggest customers and their competition has become entrenched with the customers the company has ignored for years.
The above video is taken from: Market Share Analysis: Using a B2B Sales “GAP” Analysis on Customers, Sales Territories and Your Entire Market
Marketing: In the case of marketing, the Pareto principle states that 80 percent of a company’s leads are often generated by the top 20 percent of its marketing initiatives. Companies are constantly trying to reduce their costs of leads, reduce their costs of qualified leads and ultimately, reduce their costs of customer acquisition. It’s about increasing the number of leads generated for every dollar spent in marketing. If you want to increase your marketing return on investment (ROI), then finding out if the 80-20 rule applies within your marketing strategy is a good place to start.
You can come up with your own distribution chart on lead generation by going here.
Manufacturing: Any company looking to increase its production throughput has to start by identifying the root causes of work stoppages and downtime. In this case, the rule states that 80 percent of downtime is often caused by 20 percent of the variables. This rule is applied within lean manufacturing, Six Sigma and any company pursuing continuous improvement in manufacturing.
The above graph is taken from: Manufacturing Essentials: Sample Pareto Excel Chart for Lost Time Analysis
Operations: This one is a little hard to nail down. The thinking goes that 80 percent of the work is done by 20 percent of a company’s employees. Now, I have spent a lot of time working with companies in manufacturing, supply chain management, operations, sales and marketing, and I have yet to find a way to track this rule in operations. However, it’s not needed: If you have dead weight, then do you really need a rule to point it out for you?
Inventory & Supply Chain Management: Pareto is an excellent tracking tool within your inventory. If 80 percent of your fastest selling products come from the top 20 percent of your product line, then does that help you eliminate products you’re not especially strong at? Will eliminating those products, or reducing inventory counts on those finished goods, help to reduce your overall costs of inventory? The answer to both questions is "yes."
The above video explains how to measure inventory carrying costs versus higher volume purchases
Reduce the amount of inventory you hold of slow moving, dead stock product lines and you’ll improve your bottom line. The question you must answer is the following: What products sell the fastest and which ones are dead weight and should be cut back on? Answering this question has direct consequences for your inventory counts of raw materials, semi-finished and finished goods.
The Pareto Principle is one of the rules whose parameters and distribution repeat constantly amongst many different areas. It helps define social inequality, income distribution and multiple business functions.
The idea is to use a graph to see if the distribution is applicable to a given operation within your enterprise. However, even if it’s not an exact Pareto distribution model, it’s still important to understand what that distribution is. Doing this will allow you to eliminate constant concerns, or level out this ratio and reduce the inherent risk that comes from the 80-20 rule.
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