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There are numerous small businesses that collect significant amounts of customer data but rarely do anything value adding beyond using the customer names and addresses for sending catalogs or mailings. What they do not realize is that this data is a treasure trove of information if properly utilized. One of our customers is a niche products manufacturer and distributor. They estimate a market size of about 2 to 3 million unique consumers for their products in the United States. They have about 30,000 customer records collected over the years pertaining to which products were sold, when they were sold and some customer demographic information. They also maintain a product catalog of about 4000 distinct items (SKUs).
We have written extensively about applying the Pareto 80 20 principle to a handful of business operations such as customer segmentation, product and inventory analysis. However Pareto or power law principles apply to so many different aspects of business. There are very few areas of day-to-day business activities that are not impacted by them.
Continuing on our series on applying the Pareto Law or the 80 20 rule to segment customers, this article explains how any business will eventually end up with angel customers and demon customers. But before we jump into it, a little bit of history may help set the context.
The Pareto 80 20 rule is a good tool to define product or customer segmentation relative to profitability metrics. This is important because not all customers are equal nor should be treated equally. A company should not give the same priority to a five thousand dollar customer as a fifty million dollar one. This is if it wants to keep the latter.
The 80-20 Principle is an excellent book that clearly describes not only the Pareto Law, but how to implement it to maximize profitability with minimal effort, both within a company as well as in your personal life.
We have dedicated several articles and a whitepaper to the discussion of the Pareto law or "80 20 rule" (known sometimes as "Pareto 80 20") in business. Applying the 80 20 rule or Pareto law using your business data is an indication of your analytics maturity level. There are many aspects to smart application of this famous rule and at the foot of this infographic is a short summary of the six essential facts you need to know about the Pareto 80 20 rule.
The 80 20 rule or the Pareto principle is also called the "law of critical few (20%) and trivial many (80%)" and it applies to so many facets of business and daily life, that it tends to be misused quite frequently. For example, a recent news article implied the use of the 80 20 rule in the Affordable Health Care act! When you read the article with a little bit more attention you will see that it is not the same 80 20 rule that they are talking about.
Many business analysts and managers are aware of the Pareto principle or the 80-20 rule in business. They may even have applied it certain contexts, mostly likely to sort data by Pareto ranking. Our regular readers will recall that the 80-20 refers to a distribution ratio between profits on the one hand and products/customers on the other hand: for example, 80% of the business' profits are attributed to 20% of the company's products.
A common misunderstanding many people have before they fully grasp the importance of applying the 80-20 rule or the Pareto principle is that this is the same as cost accounting or managerial accounting. Cost accounting is mostly about properly allocating costs to different products or customers or business units. This will enable business to separate the profit-producing and loss-making entities. But the confusion comes from the fact that the 80-20 rule also helps businesses to make this sort of a distinction!
While most practicing managers agree that the Pareto principle or the 80-20 rule can apply to business performance issues such as profitability, a minority believe that it never applies to them. Typically, the reasons for such objections to the 80-20 rule vary, but one reason is that the shape of the cumulative profitability curve does not "exactly" match the textbook case of the Pareto law.