Working out the 80/20 rule

You may have heard about the 80/20 rule, known also as Pareto Principle or the Law of the Vital Few.

This rule basically requires that you pay closer attention to what those “vital few” are telling you about the risks ahead for your business.

The Vital Few in business

It is not uncommon to observe something like this in business: 80% of profits from 20% of customers; 80% of sales from 20% of products; 80% of sales made by 20% of the sales staff; 80% of complaints from 20% of customers, etc.

There is nothing special about the 80%. But the key is that your business could be generating the bulk of its revenue from a few ‘star performers’ (be they customers, products, staff, etc).

The common approach of concentrating more on these top performers has its obvious merits.

It also helps to identify some of the “lower-yielding” customers (for instance) who seem to demand the greatest amount of energy from your business for the lowest return.

Risk ahead

However, discovering the 80/20 in your business may also highlight some underlying risks. For instance, what do your top customers have in common? Are they in the same industry? Are they in related industries? Are they exposed to similar risks?

This is concentration risk: a higher risk to your business from having your client base (or your products) concentrated in the hands of the few. If those few experience business difficulties, so will your business.

An example

If you own a catering services company, you may discover that the bulk of your revenue comes from a handful of, say, legal firms.

And, if you dig a bit deeper, you may discover that most of these legal firms are in Canberra.

A little more investigation and you find that most of these rely on the outsourcing of legal work by government departments.

This means that your entire business can be in jeopardy if, say, the government decided to cut back on legal outsourcing (e.g., close to election, new government, etc).

One ministerial decision and your “national” business will go from boom to bust.

What can be done?

The reason why you have such customer aggregation may not be just coincidence. Understanding why can require focused and creative detective work, but the exercise may help you discover a common underlying source of risk. Then ask yourself am I prepared to take such a risk?

Also try to understand why the majority of your customers are generating the smallest part of your revenue. There can be a wealth of information there that you can use to reduce your reliance on the “few”.

It can be exciting to discover the “critical few” in your business, but remember that the rewards they generate may carry concentration risk. Is your business earning enough to be well compensated for this risk? How can you boost the revenues from the other 80% to mitigate this risk?

Walid El-Khoury is a former ANZ executive turned business coach.