It’s Just Not Fair: The Pareto Principle and Business

The Pareto Principle

The world is not a fair place. Despite some of our best efforts we cannot seem to achieve balance (even if we could define it), equal distributions of wealth, workforces where every person contributes equally, or product mixes where each line contributes equally to sales.

It’s just not gonna happen.

The best tool to help us understand why this is true is the Pareto Principle. Popularized by management and productivity guru Joseph M. Juran the Pareto Principle is based on the work of economist Vilfredo Pareto. In his work, Pareto uncovered the fact that 20% of Italian landowners owned 80% of the land in Italy. He conducted further research and found this distribution in many other places in the world.

The Pareto Principle (often and inaccurately referred to as the 80/20 Rule) can provide some very powerful guidelines in improving the performance of our businesses, and the way we allocate precious resources in our personal and professional lives. Before we can explore the benefits though, it will be helpful to get a better understanding of what the Pareto Principle really means.

“Only a Few People Get Most of it Right”

• You can’t change the ratio.  Despite your very best efforts, if the Pareto Principle applies at all, 20% of your customers will always generate 80% of your revenues. That is, if 20% of your customers provide you with 80% of your revenues, then firing the remaining 80% won’t change the ratio. If you have 100 customers and you fire 80 of them (a la Timothy Ferriss), 4 (or 20%) of the remaining 20 will still provide 80% of your revenues. What you can change are the absolute values. Say you are spending time with 100 customers to earn $100,000. 20 of those customers represent $80,000 (or $4,000 each) in revenues. If fired the bottom half, and started rebuilding your customer base using a the old high-water mark of $4,000 as the new minimum for expected per-customer revenues, you will still find yourself with the minority of your customers contributing the majority of your revenues, but the total would be a lot more than $100,000.
• The Principle doesn’t always apply. There are other distributions in different circumstances (such as normal distribution AKA the bell curve). Also, you often need a minimum number of samples (like customers), and a range of pricing, products, or services to be available for the principle to be valid. If you only have 25 customers and you charge each of them exactly the same thing, the Pareto Principle won’t be in effect.
• The Principle can apply to more than revenues. You might find it applies to the number of word-of-mouth referrals a customer generates, or the amount of profit from the time you are investing. Discovering where the Principle applies can help you to work more effectively.
• It is not the 80/20 rule. It is a Principle. While there are many systems where the imbalance is 80 and 20, there are many others where the numbers are very different but still follow the Pareto Principle.  The numbers can be anything where a majority effect is generated a minority number: 90/6 or 60/49. You can also see that the numbers don’t have to add up to 100. Finally, where the Principle applies, 80% of 80% (64%) can also generate 20% of 20% (or 4%) of something. So 4% of your customers could generate 64% of your revenues! Now you have a 64/4 ‘rule’.

Put Your Money Where it Matters

So what does this mean for you as a small business owner or manager?

• The numbers are trivial; your focus matters. The numbers can vary but still follow the Pareto Principle. What matters is that you review where you are investing resources (time, money, and human resources) and focus on developing only those areas that give you the disproportionate value in return. I say to my clients “Ride the wave that is.” If 30% of your products are generating 75% of your sales, stop trying to boost the remaining 70% through advertising, discounts, or other means. Push that 30% harder! That doesn’t mean dump that other 70% of your inventory completely. Some of those products can bring in niche customers who might also buy the more popular items. Those products become a kind of loss leader. They key is not to invest disproportionate resources in them because you won’t get that higher investment back.
• The principle of efficiency. The best way to achieve profitability is to focus our resources where they yield the best return. The Pareto Principle teaches us that spreading resources evenly across any part of our organizations or activities is inefficient. All things being equal, trying to incent your poorest performer to do better by giving him a raise is a waste of your money.
• It’s unfair. Get over it. One of our instincts is to see things turn out fairly, generally meaning equally. Based on the Pareto Principle however, some systems (the distribution of wealth is a classic example) simply cannot be changed. In your workplace, this has serious implications. For example, no matter what you do, there will never be a situation where each member of your workforce contributes equally to the productivity of your organization. Never. Stop beating your head against that wall, and focus your resources where they will make the most difference: on the productive minority. Assuming all factors including training and experience are accounted for, if being fair means rewarding and incentivizing everyone the same way, you are wasting your resources.
• This is proof that perfectionism is a waste of time. If you know at the outset of a project that you will spend a minority of your time on a project to get the most important things into place, then you also know that any time spent beyond that yield diminishing returns. The trick is to know when to ship, so before you even start, set yourself objectives that define good enough. Work with a team that will help you set those objectives, and help you let go when you have achieved them, even if it feels like there is more to do. Understanding the Pareto Principle as it applies to your efforts can be incredibly freeing. Stop beating yourself up about those products, people, or customers who just don’t seem to respond to your best efforts. It is literally not your fault.
• The Pareto Principle supports Marcus Buckingham. Even if the numbers slide around, the fundamental assertion remains: your best strategy is always to focus your resources on your strengths. Trying to bring balance (a concept I have serious issues with) to aspects of our lives and our organizations is literally unnatural. If by balance we are striving for a linear/flat or 50/50 distribution of some kind, we may as well be fighting the law of gravity. It is not about equalizing, it is about making better that which is already good.

I work with business owners to redesign the future of their businesses. Want more out of your business? Contact me. From my home base on Vancouver Island, I provide planning and coaching support to businesses across Canada.

There’s more! Want to improve your communication with employees, partners, and customers? I help organizations improve communication through social media strategies and management-level workshops. Read my Communications & Management blog.

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