80-20 rule for profitability

This is the last in a series of articles focusing on the analytics involved in the Pareto principle or the 80-20 rule for customer profitability in business.

Even in the most successful companies, while some customers can be very profitable others have a negative impact on the bottom line.

Many companies struggle to measure the profitability of customers, distributors or agents.  This is not hard to do – even for small businesses – as they can use the 80-20 rule to increase the profitability of their customer portfolio.

In a business that has more than twenty customers, the Pareto Principle will be evident.  In this case, it’s likely that its sales, cost and profit data respond to a non-linear statistical distribution that contains the 80/20 Rule.  This means that the top 20% of customers generates close to 80% of profit while the bottom 80% of customers generates only 20% of the profit.

When the accuracy of the allocation of fixed cost and operating expenses is not clear, variable profitability measures like Sales Throughput or Contribution Margin should be used.

Only if one agrees with the allocation criteria is that measures like Gross Profit (GP) or Margin after Distribution (MAD) can be used in the analysis.

The analysis of the 80-20 profit distribution by customer can be easily done using in a spreadsheet.  The business data needs to be arranged in three or four columns: Category (Customer-Parent or account location), Value (sales revenue and profit) and Cumulative Percentage of the values; all sorted in decreasing order (of value).

80 20 rule in customer profitability resized 600

The Pareto Chart has three axes.  The horizontal axis represents the customers or accounts; The vertical axis on the left displays sales $, or profit and the vertical axis on the right side shows the cumulative percentage of the value (sales $, or profit).  The categories are displayed as bars while the cumulative percentage is an ascending curve.

Looking inside the famous Pareto principle or 80-20 rule for customer profitability, one usually finds that the top five percent of the customers generates close to 50% of the profits while the bottom 50% of the customers generates only 5% of the total profit.  The story gets worse as the bottom 40% usually generates no profit at all.  Within this group some customers are slightly profitable, some are profit neutral and some are true cash drainers.

This analysis is fundamental to understand who the strategic customers are, how they are different from key customers and standard accounts; and finally identify those in the cash drainer group to either make them profitable or yield them to the competition.  This exercise usually frees valuable resources to be re-deployed to support strategic customers, strengthening relationships as well as developing new profitable accounts. 

About the author:

Bill Cabiró founded Strat-Wise, LLC to help companies that struggle to get the information they need to increase profitability.  Strat-Wise works with their strategic business leaders, R&D, marketing and sales professionals who are frustrated, drowning in oceans of data but thirsty for the information they need to grow the business.  Bill shows them how to turn their business data into a competitive advantage to beat their competition and increase market share, profit and cash flow.  Please feel free to visit his blog and website to find unique articles and resources that support this vision.

Originally posted on Tue, Mar 06, 2012 @ 09:09 AM

Photo by Austin Distel on Unsplash

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