The 80/20 Principle: The Secret of Achieving More With Less (13 page)

Segments 10 and 11 were ones where the instrumentation group had leading market shares, but they were structurally unattractive markets. Market size was declining; there was overcapacity, and the customers held all the cards and could negotiate very keen prices. Despite the fact that it was a market leader, my client decided to deemphasize these segments and all new investment was cancelled.

Although for different reasons, the same decision applied to segment 12. The market was even more unattractive and the firm had only a moderate market share. All new marketing programs, as well as investments, were sidelined.

What about the X category, the loss makers? Here it was found that two of the three segments, 14 and 15, were large but deeply unattractive markets in which the firm was in any case only a marginal player. A decision was made to leave both segments, in one case by selling part of a factory to a competitor. The price realized was very low, but at least there was some cash benefit and some jobs were preserved in addition to the losses being stopped. In the other case operations had to be closed altogether.

Segment 13, also in the X group, experienced a different fate. Although the group lost money in this business, it was a structurally attractive market: growing at 10 percent per annum and with most competitors making high returns. In fact, although the group was making a loss after allocating all costs, the gross margin in the segment was quite high. Its problem was that it had only entered the market the previous year and was having to make heavy investments in technology and sales effort. But it was gaining market share and, if it kept up its rate of progress, could hope to become one of the largest suppliers within three years. At that stage, with higher sales to spread the costs, it could expect to make high returns. It decided to put even more effort into segment 13 so that the group could become a “scale player” (that is, operate at the minimum size necessary to be profitable) as soon as possible.

DON’T TAKE 80/20 ANALYSIS TO SIMPLISTIC CONCLUSIONS

Segment 13 in the above example helps to illustrate the point that 80/20 Analysis of profits does not give us all the right answers. The analysis is bound to be a snapshot at a point in time and cannot (to start with) provide a picture of the trend or of forces that could change profitability. Profitability analysis of the 80/20 type is a necessary but not a sufficient condition of good strategy.

On the other hand, it is undoubtedly true that the best way to start making money is to stop losing money. Note that, with the exception of segment 13, the simple 80/20 profit analysis would have given more or less the right result in 14 out of the 15 segments, comprising over 90 percent of revenues. This does not mean that strategic analysis should stop with 80/20 Analysis, but that it should start with it. For the full answer you must look at segment market attractiveness and at how well the firm is positioned in each segment. The actions taken by the instrumentation group are summarized in Figure 30.

Figure 30 Electronic Instruments Inc. actions taken after all 80/20 Analyses

80/20 AS A GUIDE TO THE FUTURE—DEVELOPING YOUR FIRM INTO A DIFFERENT ANIMAL

This concludes our strategic review of existing business segments, where it is advisable to start with 80/20 profit analyses. As we have seen, these analyses are indispensable in arriving at segment strategy. But we have still not by any means exhausted the use of the 80/20 Principle in strategy. The principle is also of enormous value in identifying the next leaps forward for your business.

We tend to assume that our organizations, and our industries, are doing pretty much the best they can. We tend to think that our business world is highly competitive and has reached some sort of equilibrium or endgame. Nothing could be further from the truth!

It would be far better to start from the proposition that your industry is all screwed up and could be structured much more effectively to provide what customers want. And as far as your organization is concerned, your ambition could be to transform it within the next decade, so that in 10 years’ time your people will look back, shake their heads ruefully, and say to each other: “I can’t believe we used to do things that way. We must have been crazy!”

Innovation is the name of the game; it is absolutely crucial to future competitive advantage. We tend to think that innovation is difficult, but with creative use of the 80/20 Principle innovation can be both easy and fun! Consider, for example, the following ideas:

• 80 percent of the profits made by all industries are made by 20 percent of industries. Make a list of the most profitable industries that you are aware of—such as pharmaceuticals or consulting—and ask why your industry can’t be more like these.

• 80 percent of the profits made in any industry are made by 20 percent of firms. If you aren’t one of these, what are they doing right that you’re not?

• 80 percent of value perceived by customers relates to 20 percent of what an organization does. What is that 20 percent in your case? What is stopping you doing more of it? What is preventing you from “making” an even more extreme version of that 20 percent?

• 80 percent of what an industry does yields no more than 20 percent of the benefit to its customers. What is that 80 percent? Why not abolish it? For instance, if you are a banker, why do you have branches? If you provide services, why not organize their provision via the telephone and the personal computer? Where might less be better, as with self-service? Could the customer be engaged in providing some of the services?

• 80 percent of the benefit from any product or service can be provided at 20 percent of the cost. Many consumers would buy a stripped-down, very cheap product. Is anyone providing it in your industry?

• 80 percent of any industry’s profits come from 20 percent of its customers. Do you have a disproportionate share of these? If not, what would you need to do to get it?

Why do you need people?

Some examples of industry transformations may help. My grandmother used to run a corner grocery store. She received orders, would pick them out, and then I (or some more reliable boy) would deliver them on a bike. Then a supermarket opened in the town. It engaged its customers in picking their own groceries and carting them back home. In return the supermarket offered a wider range, lower prices, and a car park. Soon my grandmother’s customers were flocking to the supermarket.

Some industries, such as petrol retailing, cottoned on to self-service quickly. Others, such as furniture retailing and banking, thought it was not for them. Every few years a new competitor, such as Ikea in furniture, proves that there is new life in the very old idea of self-service.

Discounting is also a perennial transformation strategy. Offer less choice, fewer frills, less service, and much cheaper prices. Eighty percent of sales are concentrated in 20 percent of products—just stock these. Another place I used to work, a wine merchant, stocked 30 different types of claret. Who needed that amount of choice? The firm was taken over by a discount chain and now a wine warehouse has opened up down the road.

Who would have thought 50 years ago that people would have wanted fast-food outlets? And today, who realizes that accessible mega-restaurants, the sort that offer a limited and predictable menu in glitzy surroundings at reasonable prices but insist that you give back the table after 90 minutes, constitute a death warrant for traditional owner-run restaurants?

Why do we insist on using people to do things that machines can do much more cheaply? When will airlines start to use robots to serve you? Most people prefer humans, but machines are more reliable and much cheaper. Machines may give 80 percent of the benefit at 20 percent of the cost. In some cases, as with cash machines (automatic teller machines, also known as holes in the wall), they provide a much better service, much faster, and at a fraction of the cost. In the next century only old fogies like me will prefer to deal with humans and even I will have my doubts.

Are carpets obsolete?

I want to leave you to your own imagination. Just one final example, where use of the 80/20 Principle has transformed a company’s fortunes and could conceivably change a whole industry.

Consider the Interface Corporation of Georgia, now an $800 million carpet supplier. It used to sell carpets; now it leases them, installing carpet tiles rather than whole carpets. Interface realized that 20 percent of any carpet receives 80 percent of the wear. Normally a carpet is replaced when most of it is still perfectly good. Under Interface’s leasing scheme, carpets are regularly inspected and any worn or damaged carpet tile is replaced. This lowers costs for both Interface and the customer. A trivial 80/20 observation has transformed one company and could lead to widespread future changes in the industry.

CONCLUSION

The 80/20 Principle suggests that your strategy is wrong. If you make most of your money out of a small part of your activity, you should turn your company upside down and concentrate your efforts on multiplying this small part. Yet this is only part of the answer. Behind the need for focus lurks an even more powerful truth about business, and it is to this theme that we turn next.

5

SIMPLE IS BEAUTIFUL

My effort is in the direction of simplicity. People in general have so little and it costs so much to buy even the barest necessities (let alone the luxuries to which I think everyone is entitled) because nearly everything we make is much more complex than it needs to be. Our clothing, our food, our household furnishings—all could be much simpler than they now are and at the same time be better-looking.

H
ENRY
F
ORD
¹

We saw in the previous chapter that nearly all businesses have within them chunks of business with widely varying profitability. The 80/20 Principle suggests something quite outrageous as a working hypothesis: that one-fifth of a typical company’s revenues account for four-fifths of its profits and cash. Conversely, four-fifths of the average company’s revenues account for only one-fifth of profits and cash. This is a bizarre hypothesis. If we assume that one such business has sales of $100 million and total profits of $5 million, for the 80/20 Principle to be correct $20 million of sales has to produce $4 million of profits—a return on sales of 20 percent; while $80 million of sales has to produce just $2 million of profits, a return on sales of just 1.25 percent. This means that the top fifth of business is
sixteen
times more profitable than the rest of the business.

What is extraordinary is that when it is tested, the hypothesis generally turns out to be correct, or not very far wide of the mark.

How can this be true? It is intuitively obvious that some business chunks may be considerably more profitable than others. But 16 times better? It almost beggars belief. And, routinely, executives who commission product-line profitability exercises often do refuse to believe the results when first presented with them. Even when they have checked the assumptions and verified them, they still end up baffled.

The next stage is often for managers to refuse to get rid of the 80 percent of business that is unprofitable, on the apparently reasonable grounds that the 80 percent makes a very large contribution to overheads. Removing the 80 percent, they say, would clearly decrease profits, because you simply couldn’t remove 80 percent of your overhead in any sensible time frame.

When faced with these objections, corporate analysts or consultants generally give way to the managers. Only the most horribly unprofitable business is removed. And only minor efforts are made to increase the extremely profitable business.