The Pareto Principle: Achieving More With Less

Contributor:  Richard Koch
Posted:  12/08/2008  12:00:00 AM EST
Rate this Interview: (4.0 Stars | 29 Votes)

The Pareto Principle, an important Lean Six Sigma management theory, states that, for many events, 80 percent of the effects come from 20 percent of the causes. Joseph M. Juran, a business management thinker, formulated the Pareto Principle, or the 80-20 Principle. Juran named the Pareto Principle after Italian economist Vilfredo Pareto, who had observed in the early 1900s that 80 percent of Italian income went to 20 percent of the population.

Today, the Pareto Principle is still relevant to Lean Six Sigma. Richard Koch, a preeminent thinker on the Pareto Principle as it applies to business management, demonstrates in his book The 80-20 Principle how to achieve more with less in a business context. Koch talks with the Process Excellence Network about 80-20 applicability in today's business environment.

How does the Pareto Principle relate to Lean Six Sigma or other business process management methodologies?

Well, it started with Joseph Juran and quality control in the early 1950s. Juran used the 80-20 Principle to focus on the most frequent and serious causes of poor quality. “Fix them first,” he told his clients, who pretty soon were mainly Japanese. And they did. From being a shattered nation with negligible exports, they became a powerhouse in the 1980s and a pesky challenge to the United States in many landmark industries—notably cars and consumer electronics.

Progress is all about using energy, where small dollops go a long way. The Pareto Principle always tells us where the bang for the buck is greatest.
 
The 80-20 Principle, a scientific law proven in business and economics, claims the great majority of results come from a small minority of causes or effort. How does this fall within a Lean Six Sigma framework? I think of the 80-20 Principle not so much as a law but as an observation. It’s not always true—but the most interesting and profitable things do follow an 80-20 or 99-1 distribution. There we can make a lot of money for relatively little effort.

What are the business case studies you have seen that utilize this framework for the Pareto Principle?

Well, it’s difficult for me to single one out because almost every business where I’ve been involved has found that a small proportion of its customers and products give nearly all its profits and cash. One example that comes to mind is HP Foods, which made all kinds of canned food and sauces.

We found that just two of its smallest units—Lea & Perrins, the legendary Worcester sauce, and Daddies, the thick brown sauce—comprised only 15 percent of sales and made up a stunning 120 percent of fully costed profits.

A more recent example includes a large and successful online business that I can’t name for confidentiality reasons. I was told that 80-20 analysis did not work because the incremental cost of serving even small customers was so small—the long tail at work. And if we looked at customers by size—revenues to the firm—it seemed to be true. The biggest customers were less profitable than the medium-sized customers and a bit more than the smallest customers. There was a lack of 80-20 there. Then somebody had the idea that there is a big difference among customers of the same size. Some of the big customers require a lot of marketing effort, but manage to pay relatively little because of the way their business works.

Other big customers require no marketing, yet pay quite a lot. When we looked at it that way, the big customers split into two groups—a small one, which was massively unprofitable, and a larger one, which made profits quite disproportionate to their revenues.

By re-jigging the pricing to get eight times more revenues from the first group, we increased the total profits of the firm by nearly 30 percent. We lost a few customers, but only a handful. We had a reverse Pareto Principle to start with—10 percent of revenues comprising virtually all the losses made by any customers. Now of course the 80-20 Principle doesn’t work there, because all customers are profitable.

But there’s another way to look at 80-20—not at the level of the firm, but at the level of the economy or the stock exchange as a whole. You will find that 5 percent of businesses are what the Boston Consulting Group called “star businesses”—the leaders in a high-growth market. And these firms, over their lifetimes, have constituted the great majority of cash and growth in market value in the economy. They’re ventures such as Coca-Cola (for over 100 years, until the growth slowed in the 1990s), McDonald’s (for 50 years until the 1990s), Intel, Microsoft, eBay, Google and the online betting exchange Betfair. So if you want to make a lot of money, all you have to do is find star businesses when they are young.

With consideration to the Pareto Principle, how are companies able to leverage 80-20 analysis to remain sustainable during this economic downturn? What advice can you give companies that are in dire need of cutting costs?

Last question is easier—cut costs! But make sure that cost cutting doesn’t hurt your ability to service the top 20 percent of your customers by profitability, or to find new customers like them. Cut costs that stymie your unprofitable customers, or make your loss-making products unattractive to buy.

Cost cutting is one essential thing. But working out who your most and least profitable customers really are is another. It ain’t always simple to do this, but it’s always possible.

How can companies make small changes in their programs that won’t overhaul their entire operation but that follow the Pareto Principle?

The small, incremental changes that make the biggest difference are 1) pricing and 2) finding more super-profitable customers. Neither one of these affects a firm’s operating system, neither are high risk and both offer a very quick payback.

Richard Koch Contributor:   Richard Koch


comments powered by Disqus


Advertise With Us

Learn how to sponsor a webinar with us?

Join Process Excellence Network