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80/20 Theory of the Firm How to create the greatest stakeholder value with the least expenditure of assets and efforts. |
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Applications of the 80/20 Theory of the Firm |
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80/20 Analysis of Profits |
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To achieve sustainable growth through effective reallocation of resources, conduct continuously an 80/20 Analysis of profits by its different categories:
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Related Chapters of the Business e-Coach: |
80/20 Principle and Your Business
The key theme of the 80/20 Principle applied to business is how to create the greatest stakeholder value and generate most money with the least expenditure of assets and efforts. Any individual business can gain immensely through practical application of this Principle. The most important use of the 80/20 Principle is "to isolate where you are really making the profits and, just as important, where you are loosing money. Every business person thinks they know this already, and nearly all are wrong. If they had the right picture, their whole business would be transformed".
The game is to spot the few places where you are making great surpluses - be that a product, a market, a customer type, a technology, a distribution channel, a department, a country, a type of transaction, an employee, or a team - and to maximize them; and to identify the places where you are loosing and get out.
Simple is Beautiful
"Because business is wasteful, and because complexity and waste feed on each other, a simple business will always be better than a complex business". To succeed in managing change and transforming your business by applying the 80/20 Principle, you need to demonstrate that simple is beautiful and why. Unless you understand this, you will never be willing to give up underperforming 80% of your current business and overheads. "The way to create something great is to create something simple... Progress requires simplicity; and simplicity requires ruthlessness".
"The truth is that the unprofitable business is so unprofitable because it requires the overheads and because having so many chunks of business makes the organization horrendously complicated". And complexity means decay. Internal complexity has huge hidden costs and depresses returns more effectively than anything else.
"A complex business can be made more simple and returns can soar. All it takes is understanding of the costs of complexity (or the value of simplicity) and courage to remove at least four-fifths of lethal managerial overhead".
Improving Your Margins
"Margins - between value and cost, between effort and reward - are always highly variable". High-margin activities constitute 20% of total activities but 80% of total margins. You must interfere with this natural allocation of resources unless you wish to see these imbalances to grow even further. Acknowledge the reality that the majority of what your firm does is worth much less than the minority of high margin activities and reallocate resources to take your firm to a new higher level. Don't stop there - do that again.
Effective Selling and Competing
80/20 Principle helps you to direct your attention where the real threat of competition exists. 80% of your revenue comes from 20% of your customers. Know who your top revenue-producing customers are and make sure you meet their needs to win their loyalty. "Focusing on 20% of your customers is a great deal easier than focusing on 100% of them." Being customer centered on all your customers is impossible. "But cherishing the core 20% is both feasible and highly rewarding".
The four steps to lock in your core customers:
Know who they are
Provide exceptional or even outrageous service to them
Ground innovation in the relationship with this group - target new products and services at the core 20% of customers, developing them for and with this group
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Aim to keep your core customers for ever.
80/20 Principle and Quality Improvement
The 80/20 Principle was one of the 'vital few' inputs to the quality revolution which took place between 1950 and 1990. The observation that losses are always maldistributed in such as way that a small percentage of quality characteristics always contributes a high percentage of the quality loss encouraged quality practitioners to concentrate on diagnosis of the few defects causing most of the problems. According to the 80/20 Principle, effort should be focused on dealing with the 'vital few' sources of off-quality products, rather than tackle all the problems at once. If you remedy the most critical 20% of your quality gaps, you will realize 80% of the benefits.
Case in Point: Ford Electronic Manufacturing Corporation
The 80/20 Principle is used in many corporate quality management programs. In Ford Electronic Manufacturing Corporation's quality program that won the Shingo prize, just-in-time programs have been applied using the 80/20 rule (80% of the value is spread over 20% of the volume) and top-dollar usages are analyzed constantly. "Labor and overhead performance were replaced by Manufacturing Cycle Time analysis by product line, reducing product cycle time by 95%".
