Unlocking Hidden Revenue: How Conducting an 80–20 Analysis on Customers Can Boost Your Business’s Bottom Line
The statistical way to identify business growth and harvest areas.
After reading this you should be able to :
- Gain a better understanding of their most valuable customers and how to retain them.
- Identify patterns and trends in customer purchase behaviour that can be leveraged to increase revenue.
- Focus marketing efforts on the most valuable customer segments, leading to more effective and targeted campaigns.
- Develop personalised offers and promotions to increase customer loyalty and repeat business.
- Improve customer service and support for high-value customers, leading to increased satisfaction and retention.
- Monitor and adjust strategies to maximise revenue from the most valuable customers over time.
Keeping customers coming back for more is a crucial aspect of building a successful business. By creating loyal customers who repeatedly purchase from your company, you can increase revenue and improve brand reputation.
But to create loyal customers one first needs to understand who are loyal customers or who can be converted to one.
Things like offering excellent customer service, building relationships, offering loyalty programs and keeping in touch should be ideally done for each customer. But there are other ways to achieve higher efficiency with less efforts.
Enter the 80-20 rule.
The 80–20 principle, also known as the Pareto principle, states that 80% of the results are generated by 20% of the causes. Applied to business, this means that 80% of a company’s revenue typically comes from 20% of its customers.
Now don’t get stuck on numbers, it simply asserts that a minority of causes, inputs or effort usually lead to a majority of the results, outputs or rewards. Fractions for your business can be either 60–40, or 70–30 or even 95–5, i.e. 5% of the customers are responsible for 95% of the company’s revenue.
the majority, that have little impact
a small minority, that have a major, dominant impact.
Pareto principle (80–20) applies to many areas of life and not just business.
The pattern underlying the 80/20 Principle was discovered in 1897, by Italian economist Vilfredo Pareto (1848–1923). His discovery has since been called many names, including the Pareto Principle, the Pareto Law, the 80/20 Rule, the Principle of Least Effort and the Principle of Imbalance. By a subterranean process of influence on many important achievers, especially business people, computer enthusiasts and quality engineers, the 80/20 Principle has helped to shape the modern world.
In his book The 80 20 Principle, Richar Koch writes that it is perhaps unfortunate that the numbers 80 and 20 add up to 100. This makes the result look elegant (as, indeed, would a result of 50/50, 70/30, 99/1 or many other combinations) and it is certainly memorable, but it makes many people think that we are dealing with just one set of data, one 100 per cent. This is not so.
I encourage you to read his book to understand more about this hidden gem.
How companies can use the 80/20 Principle to raise profits
Unless you have used the 80/20 Principle to redirect your strategy, you can be pretty sure that the strategy is badly flawed.
To arrive at a useful business strategy, you need to look carefully at the different chunks of your business, particularly at their profitability and cash generation. Unless your firm is very small and simple, it is almost certainly true that you make at least 80 per cent of your profits and cash in 20 per cent of your activity, and in 20 per cent of your revenues. The trick is to work out which 20 per cent.
Where are you making most money?
Identify which parts of the business are making very high returns, which are just about washing their faces and which are disasters. To do this we can conduct an 80/20 Analysis of profits by different categories of business:
- by product or product group/type
- by customer or customer group/type
- by any other split which appears to be relevant for your business for which you have data; for example by geographical area or distribution channel
- by competitive segment (Segmentation is the key to understanding and driving up profitability)
The best way to examine the profitability of your business is to break it down into competitive segments. While analyses by product, customer or any other relevant split are usually very valuable, the greatest insights come from a combination of customers and products into ‘dollops’ of business defined with reference to your most important competitors.
Identifying competitive segment is not as easy as it sounds, and probably that is why very few organizations are able to break up their business in this way. So just ask yourself two simple questions:
Do you face a different main competitor in this part of your business compared to the rest of it?
If the answer is yes, then that part of the business is a separate competitive segment (or simply segment for short).
But even if the part of your business you are looking at has the same competitor as another part of your business (for example, your main competitor in Product A is the same as in Product B), then you need to ask another question.
Do you and your competitor have the same ratio Of sales or market share in the two areas, or are they relatively stronger in one area and you relatively stronger in another?
For example, if you have 20 per cent market share in Product A and the largest competitor has 40 per cent (they are twice as big as you), is it the same ratio in Product B: are they twice as big as you there? If you have 15 per cent market share in Product B but your competitor only has 10 per cent, then there is a different relative competitive position in the two products.
Instead of starting with a conventional business definition, such as a product or the output from different parts of your organisation, thinking about competitive segments lobs you straight at the most important way to split and think about your business.
Let’s take an example of a hypothetical QWERTY Corp.
After analysing, we define 15 large segments of QWERTY. Each segment had a different competitor or different competitive positions. We then analyse the split of sales and profits for each of the segments, and this is shown in Figure 1.
To highlight the imbalance between the split of revenues and profits, we can again construct an 80/20 Table (Figure 2).
We can see from these figures that the top six segments comprise only 26.3 per cent of total sales, but 82.9 per cent of profits: so here we have an 83/26 rule.
What can QWERTY do to boost profits?
The most profitable quarter of the business, segments 1–6, can be classified initially as top priority A businesses, and can be grown most aggressively. More than 80 per cent of profits came from these segments, and if they receive only an average amount of management time in line with their turnover than that’s even a better news.
A decision can be taken to raise the amount of time spent on these businesses to two-thirds of the total. The salesforce focused on trying to sell more of these products, both to existing customers and to new ones. It can be decided that whether the group could afford to offer extra services or to cut prices slightly and still enjoy very good returns.
The second set of businesses comprised segments 7–12. In total these made up 57 per cent of total sales and 49 per cent of total profits; in other words, on average, slightly below-average profitability. These segments are classified as B priority, although clearly some segments in this category (such as 7 and 8) are more interesting than others (such as 11 and 12). The priority to be accorded to these segments also depended on the answers to the two questions posed at the start of the article, that is, on whether each segment was a good market to be in and on how well the company was positioned in each segment.
At this stage, a decision can be taken to cut the amount of management time spent on the B segments from around 60 per cent to about half this level. Prices on some of the less profitable segments can also be raised.
The third category, designated X priority, comprised the loss-making segments 13–15. A decision on what to do about these segments should not be taken hastily and must be deferred, until after analysis of market attractiveness and the strength of the company’s position in each market.
Figure 3 summarizes the results.
Before reaching final decisions on any segment, however, the company’s management must examine the two other questions, besides profitability, that are key to strategy:
Is the segment an attractive market to be in?
How well is the firm positioned in each segment?
Figure 4 shows the final strategy conclusions for QWERTY Corp.
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.
Pareto principle is not just about business. It uncovers the relationship of level of action with its impact. You can use it to manage time, conquer difficult tasks, continually improve your skills, identify money rich sources and even happiness (as per Richard Koch).
Step 1: Identify the company’s top customers
To begin an 80–20 analysis, you must identify the top customers who generate the most revenue for your business. This can be done by reviewing sales data and analyzing customer purchase patterns. Look for customers who have made the most purchases, spent the most money, or purchased high-margin products.
Step 2: Segment the customers into groups
Once you have identified your top customers, you can segment them into groups based on their purchase behaviour. This can include factors such as purchase frequency, order size, and product type. By segmenting your customers, you can identify patterns and trends that will help you to focus on the most valuable customers.
Step 3: Analyze the customer segments
After segmenting your customers, you can analyze each segment to determine the value that they bring to your business. This can be done by calculating the revenue and profit generated by each customer segment. Look for segments that generate the highest revenue and profit, and focus on these segments to increase revenue.
Step 4: Develop strategies to increase revenue from top customers
Once you have identified your top customers and analyzed their value to your business, you can develop strategies to increase revenue from these customers. This can include targeted marketing campaigns, personalized offers and promotions, and improved customer service. By focusing on your top customers, you can increase their loyalty and generate more revenue from them.
Step 5: Monitor and adjust your strategies
Finally, it is important to monitor the effectiveness of your strategies and adjust them as needed. Track customer behaviour and sales data to determine whether your strategies are generating the desired results. If not, adjust your strategies and try again.
In conclusion, conducting an 80–20 analysis on a company’s customers is a valuable tool for increasing revenue. By identifying the top customers, segmenting them into groups, analyzing their value, developing strategies to increase revenue, and monitoring and adjusting those strategies, you can focus on your most valuable customers and generate more revenue for your business.
Hi, I am Mahesh.
I am a Machine Learning Engineer and I write about how statistics and machine learning can help businesses.
Connect with me on LinkedIn: https://www.linkedin.com/in/maheshrajput