80-20 rule for profitability

Can Pareto 80-20 rule tell angels and demons apart? Yes – when you are referring to customers! 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.

Wilfredo Pareto, was an Italian civil engineer, who spent most of life working on economics and sociology. In the late 1800’s he discovered a law of distribution of income.

Pareto found out that in 19th century England, 80% of the wealth and land ownership was controlled by 20% of the people, while 80% of the people only accounted for 20% of wealth.  Later, Pareto performed similar studies in Italy and Switzerland surprisingly finding the same distribution of wealth.

His empirical 80 20 rule was decades later mathematically explained as the cumulative effect of a power law probability distribution named Pareto Distribution.

This type of statistical distribution describes that large impact events are rare, but low impact ones are very frequent.  For example intense earthquakes are infrequent but small ones occur with fairly high frequency.

Similarly in business while very few customers make high dollar value purchases, many customers make low value ones.  This typically fits the 80 20 Principle by which 80% of revenue is generated by 20% of customers.

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.

Taking a closer look at the Pareto Principle 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.  Note that the top 5% of customers are 100 times more profitable than the bottom 50%.

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.

Identifying customers in each group is very important to differentiate critical strategic customers (A) from key customers (B) and standard or “garden variety” accounts (C); 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 profitable strategic customers and develop additional customers that fit that profile.

Do you know which group each one of your customers falls into? Perhaps its time for you to dig into the Pareto 80-20 rule to figure it out …

Originally posted by Bill Cabiro on Wed, Sep 19, 2012 @ 08:08 AM

Photo by Austin Distel on Unsplash

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