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The Pareto Principle -- aka The 80/20 Rule or the Principle of Imbalance -- says that 80% of the
outputs in virtually any endeavour are generated by 20% of the inputs.
Vilfredo Pareto found that 80% of the land in Italy was owned by 20% of the population in
1906.
Volkswagen found that roughly 20% of the automobile build combinations were responsible for
80% of the profit margin.
Microsoft found that 20% of its software bugs caused 80% of the errors.
These 80/20 examples are ubiquitous in business. And the Principle extends farther. You can
80/20 the 20% as well, leading to 90/10 or even 99/1 splits.
ITW had a problem in 1980. Their costs kept going up, but they couldn’t recover the money in
higher prices. Competition and rising costs were driving margins down with no end in sight.
“When ITW began experimenting with 80/20, the company’s margins were increasingly being
challenged by a downturn in the automotive industry and competition from highly efficient
Japanese manufacturers.”
Jim [Farrell] would say, ‘Give me all the part numbers in this segment of our business.’ And he’d
line them up and say, ‘Who’s the biggest, who’s the smallest,’ and he’d put the numbers into a
computer and, lo and behold, 20 percent of products gave you 80 percent of revenue and 20
percent of customers gave you 80 percent of your dollars. With one database of products after
another, they’d all be the same.”
Armed with this information, senior executives began to sell the 80/20 concept throughout
ITW’s business units. This innovative thinking began to percolate, but little actual change
ensued.
“People didn’t want to change it because they were all very focused on short-term incentive
plans. That meant that they weren’t going to adapt what we were trying to teach them. So we
changed the incentive plans.”
The result was an economic transformation across almost every business unit, unlocking
massive shareholder value. 80/20 allowed ITW to increase its profit margins, drive 19%
compound annual returns, and continue acquiring companies to reach over $18 billion in
revenue.
Source: https://www.itw.com/wpcontent/uploads/2012/12/043012_ITW100
Years_NookTablet.pdf
Here the top 50 customers (quadrant 1) generate 89% of revenues and 150% of total
profits. The bottom 50 customers (quadrant 4) generate only 1% of revenues and -40 of total
profits. A major difference!
At this stage you’ll likely start hearing objections as the data tells its story:
“We can’t get rid of those little customers -- we’d be putting all our
eggs in one basket!”
“Our big customers didn’t start out big. They started as small accounts
and we helped them grow.”
80/20 Strategy: Get customers to move from Quad 2 to Quad 1. Incentivize the sales team to
drive this transition with higher commissions. You can also incentivize Quad 2 customers with
better pricing on the ideal SKU mix to move up to Quad 1.
Quadrant 3: Transactional
80/20 Strategy: Move these customers away from direct outside sales to inside sales and
distributors. Establish a minimum order quantity and introduce quantity-based pricing to
incentivize larger purchases.
80/20 Strategy: These low value, yet high effort customers add negative value to the business
by “pirating” resources and profits. Raise the prices substantially for these 80% of companies.
Because order quantity tends to be very small in this quadrant, even large price increases are
likely to go unnoticed. Customers won’t leave but margins will improve substantially.
Source: Finding Hidden Profit Through Quad Analysis (Strategex, Nov 1,
2015) https://strategex.com/finding-hidden-profit-through-quad-analysis/
What you want is higher margins as you move from Quad 1 down to Quad 2, 3 and 4. As
customer size drops, orders get progressively smaller so margins per order should be higher.
The quadrant chart below shows what we typically find -- misaligned margins across the
quadrants.
Increasing value at this stage is driven by segmenting your customers by customer value (e.g.
size, growth, mix, etc.). Focusing on each segment, you then steps to raise and align profit
margins.
This process involves significant analysis and potentially customer interaction to identify
pockets of value. Asking these questions can help:
Using a version of this methodology ITW has achieved a 19% compound annual shareholder
return over 25 years. In addition, every acquisition ITW has made became profitable -- an
incredible 100% batting average.