80/20 Business Analysis
We talk about the 80/20 Rule a lot in Profit Savvy. This article looks specifically at how to analyze many parts of your business with 80/20 to rapidly improve productivity. It is a mix of Yellow and Blue Belt
The best approach to doing an 80/20 analysis of your business is to focus on four major determinants of your business success. These are:
- Grouping by Product or Product Type.
- Grouping by Customer Type.
- By Competitive Segment.
- By other splits that may be relevant to your particular business such as the geographical area that you cover subdivided into markets or different distribution channels like retail and online.
Before we look at each of these, we will assume you know how to rank the element of your business under inspection according to the 80/20 approach so you can find the best and worst performers. If you are not familiar with using a spreadsheet for this purposes, first refresh your memory at 80/20 Analysis Methodology.
It doesn't matter particularly where you start your 80/20 business analysis but possibly the most convenient is with the product range so that you can identify products that are most profitable and least profitable to you.
When looking at products, we should determine the total sales volume of that product and then try to estimate the profitability.
Your profit will be the sales price less the purchase price and less any direct costs, such as sales and delivery and some share of the indirect costs and overheads, such as a shop or office space, administrative staff overheads and so on.
A whole body of knowledge has grown up around trying to estimate these costs and it is called Cost Accounting. Almost certainly, Cost Accounting will not be a very effective indicator of your costs because a lot of the decisions about how to allocate costs are quite arbitrary. It is also an extremely time consuming process and runs the risks of being continually out of date as your business may be much more dynamic than the cost accounting system can keep up with.
In your first, 'quick and dirty', pass through this data it might suffice to ignore the overhead costs on the basis that they are apportioned equally across all of your product groups. We can simply take into account the direct costs that you know for that product such as purchase price from you wholesaler, sales people allocated to that product range and delivery costs.
it will be rather more difficult to estimate the purchase price if you make it rather than buy it from a wholesaler. As a 'quick and dirty approach', try using the purchase price of a similar product from a wholesaler and remove the estimated wholesaler markup margin.
Run your collected product data through the 80/20 Analysis Methodology to identify your best and worst products using the 80% cutoff point as a guide.
Before dropping a product, give some thought as to whether it might be a poor performing product because you are not servicing it properly with sales and marketing.
You probably have enough market knowledge already in your head to decide whether a poor performer is a genuine poor performer or a good one which is starved for attention. If it is starved for attention, give some thought to how to move it up the line. It is quite common for poor performers to get all the attention to try and boost them while the good performers are left to struggle for themselves. This analysis is meant to put the priority for attention back where it should be; on actual or possible best performers. But, realize that unless it gets to one of your very best sellers, it may not be worth the attention, in the short term, to move it up the ranks if that distracts you from placing the maximum attention on the 20% that are already very successful and trying to grow them which is the most likely area to be successful.
Based on this information, you can probably begin to make some decisions for yourself on which products to drop and which to promote more actively.
To some extent, this will be a determinant of which customers you then go looking for. It is probably not wise to allow a good customer in a poor product area to lapse. Fortunately, it's probably not so likely that good customers will be purchasing the products that don't do too well for you unless of course your pricing or your cost of service is such that you are supplying a product that is in demand but in an unprofitable way.
Repeat the exercise in the spreadsheet for each of your customers.
In the columns in your spreadsheet setup:
- Customer by individual customer if you have comparatively few or alternatively group customers by type if you have a lot. An example of customer type might be online versus over the counter sales.
- Total sales to that customer or customer group.
- Cost of the product, your purchase price for the product sold to those customers.
- Cost of servicing those customers which, once again may well be the direct sales effort and delivery cost.
- Calculate the profitability, the profit share and the cumulative profit share as previously. Consider putting the results into a Pareto Chart if you want a visual analysis but it is not necessary.
From this analysis you will again find that you have some highly profitable customers, some low and perhaps even loss making customers and a majority of customers that lie somewhere in the middle. It may be surprising to you that some of your high volume customers are not necessarily your most profitable customers because they demand a better price, take more time to service and so on.
Once again, you would put on your thinking cap as to which of these customers are the ones you want to grow if that is possible and which you might quietly let go or service in a different manner. It's entirely possible you might even give thought to closing a retail outlet and going wholly online, for example, if the cost of the retail operation was significant.
Competitive Segment Analysis
If your business sells a range of products, it's possible that each product group appeals to some different segment of your customer base and may have different major suppliers and other creditors.
Many business theorists say that you should be looking for a market niche where you can prevail. One of the most prominent was the very successful CEO Jack Welch who ran the huge company General Electric. He steered the company into dumping many of their business departments that could not be number 1 or 2 in the industry saying they could not have a strong competitive position. As another reality check on focus, you will be able to name the top 2 cola companies, (hint Coke and Pepsi) but what is number three. The same is likely to apply, for example, to pizza, hamburgers and so on.
A good market niche is one that:
- Has comparatively few strong competitors.
- You enjoy working in (life is too short to work in uninteresting areas).
- You have the knowledge and ability to do the job well.
- There is no reason for customers not to want to trade with you.
- It's difficult for competitors to enter the space to compete against you.
- The market is sufficiently large and profitable to make your business a healthy income.
(Note: we should try to look here at how to identify a competitive segment. It's possibly something like product sales ratio multiplied by customer ratio on the basis that the ones where you are already selling profitable products to profitable customers are the best market for you to focus on. All the others fall into more or less competitive markets and the least popular one to work in would be one with low return on sales multiplied by low return on customer)
It will not be a Competitive Segment if you face the same business competitors in what you otherwise think would be separate Competitive Segments.
Therefore, you would tend to take each of your product groups and separate them into segments according to whether or not they have different major business competitors for you. It may be that, if you work in a number of different geographic locations, these Competitive Segments may be different due to the presence of stronger or weaker business competitors in those same geographic markets.
Arrange your Competitive Segments in the now familiar Excel Spreadsheet to identify where they lie on the profitability range within your business.
You now have an idea of which market niches you can most productively operate in.
You could argue that you are going to start up in a new (to you) niche. As you have no data, this would probably best be considered a “business start-up” and decisions will be made with the start-up mental framework (see Start-up article) rather than a business with a trading record.
For a different slant on which competitive segments you should be working in, see the Boston Consulting Group Growth Share Matrix article.
Different Results In Different Segments
It may well be that you operate in a number of different geographic segments and you get different results for the Competitive Segment Analysis and consequently the Product Analysis may also be different.
This is most likely due to the presence or absence of strong competitors in that geographic location.
If you apply an 80/20 analysis to the products that are successful in your separate geographic regions, you will identify that some regions are far better for you than others and some regions may be making losses. This can be particularly true if you have location specific overhead costs, like a separate office, sales staff or retail outlet in each of your geographic regions.
An 80/20 analysis will suggest to you if any of these regions should be potentially closed down or amalgamated in some way to reduce the overhead costs.
Similarly, if you have different distribution channels (for example retail and online) , the 80/20 analysis may identify which of those channels are the best for you in terms of profitability. It might be that you become more profitable by closing down some channels and focusing your time and money and other resources on the channels that are most productive for you.
Focus on the Extremes Not the Middle
The purpose of the 80/20 analysis above is not so much to give you black and white answers to the issues that you face but to identify areas where your attention might be most successfully focused.
If something is clearly outstandingly good or outstandingly bad, quick action on both of these outlying results (called 'outliers') is likely to maximize your productivity and profitability improvements.
Working on the mass in the middle is most likely to only move them a little bit in one direction or another. It will require a lot of effort and resources to move the needle even a little bit in this middle ground. Best to not put too much attention here if it detracts from fixing the very good or very bad.
It is common sense that one of the best ways to start making money is to stop losing money.
No doubt it's worthwhile spending time on the least profitable of the segments; either to remove them entirely or to try to restructure them to reach the profitability levels that you are capable of. Again you would probably only focus your attention on the comparatively few of your least profitable products that have the capacity to become best or at least good selling products. Spending any amount of time on something that's a real "Dog" (see Boston Consulting Group Growth Share Matrix article) is surely a waste of your time.
Unfortunately, this may mean that you may need to give up some of your "babies" and that can be sometimes quite difficult. However, there is quite a well-developed body of knowledge now to do with start up businesses that identifies these laggard products and "pivots" away from them into more productive areas. (See Startup Diet)
Now that you have a reasonably good idea of the productive and unproductive parts of your business, you can pause and reflect on the overall implications of this 80/20 analysis.
- 80% of the profits made by all businesses in all industries are likely made in 20% of those industries. If you are not presently in a highly profitable industry, you could ask yourself whether you should move more towards an industry that is profitable. Alternatively ask yourself what you can take from those highly profitable industries by introducing those success factors into your own industry.
- 80% of the profits made in any industry are likely made from 20% of the companies in that industry. If you are not one of those 20% most profitable, what can you learn from what they are doing to introduce to your business.
- 80% of the value perceived by customers relates to 20% of whatever your business does. It might be your product range, your level of service, or your price for example. The analysis that you have done on your products and customers should begin to indicate to you where your value in the minds of your customers lies. You can then focus on making more and more of those high customer value items.
- 80% of what any particular industry does is likely to yield about 20% of the benefit perceived by its customers. What is that 80% that's not contributing a great deal to your customers satisfaction and how much of it can be eliminated? Conversely, the 20% that does appeal to customers should ideally be reinforced in your business operation.
- 80% of the benefit from any product or service can be provided for by 20% of the total cost of providing your full product range. Many of your products are quite expensive to provide to your customers. Is it possible that you can provide a range of product types from high priced luxury to low price basic in the same way that the car industry provides a range of cars for each major brand from luxury to basic? See how 80/20 can forecast customer volume prepared to pay a different price pint at the 80/20 Multipliers article.
- With 80% of any industry’s products, the profits come from 20% of its customer base. Do you have your fair share of these or is there some action you could take to gain a larger share of these highly profitable customers?
Elsewhere we have shown that a focus on the best and most productive parts of your business is likely to have around a 16 times greater effect than spreading your attention on your business across all sectors, or even worse, on the low yielding areas of your business in possibly futile attempts to improve those poor performers. There might be a lot of wisdom in adopting a policy along the lines of "feed a fever, starve a cold" whereby you spend most of your time (e.g.. 80%) on those most profitable aspects of your business to grow them as rapidly as possible. (see 80/20 Multipliers article for 16 times explanation.)
Economies of Scale
A beneficial bi-product of focusing on the comparatively few highly successful parts of your operation is that you are likely to begin to get the benefits of economies of scale.
As you buy more of a product you are likely to be able to obtain quantity discounts from your suppliers. You don’t necessarily need to pass on to your buyers because they are used to buying at your existing price. This gives you a better profit margin.
Alternatively, if you choose to pass the saving on, the price that you offer may be lower than your competing sellers and hence attract more of the big buyers to you.
Scale also means that your servicing costs may be amortized over more product or more customers.
Very often there are basic fixed costs to having a sales person and they are comparatively "lumpy" costs. You either have a sales person or you don't, you can't have 1/3 of a sales person (unless of course you outsource it). Therefore, as your sales volume goes up its quite likely that your service costs will not go up at the same rate as you consume the surplus capacity in your system (like sales staff) before you have to supply more resources. This improves your profit margin and/or allows you to reduce your prices even further.
When you have many products and/or many markets and/or many customers, your efforts to focus and scale are diluted by the area you need to service. Reducing the complexity in several of those products/customer/market areas can allow you to move towards better scale in the ones that you continue to service.
Even seemingly small changes can double your sales and triple your profit was we illustrate in the 80/20 Sales Growth article.
Contribution to Overhead
A common response to trying to re-size or downsize aspects of your business is the claim that those under the magnifying glass "contribute to overheads" and therefore should not be closed.
In any business that has been running for a reasonable period of time, overheads are likely to have mounted up. Expensive head office locations, expensive senior management and their correspondingly expensive perks, like cars and travel, can slowly mount up. Also some of the staff are beyond their ‘use by date’ (see e.g.. Peter Principle: promotion to incompetency).
Managing the Weaklings
Having identified and ranked your various competitive segments for your business, you can apply 3 extra strategies to the less productive segments.
1. Shut down
Firstly, you can close those segments altogether.
This is where the "contribution to overheads" argument discussed above starts coming up.
In fact your worst performers may be actually contributing to overhead by being loss making or close to loss making activities. Closing them down may actually boost your profitability.
This will only happen if all of the components that are contributing to the low profitability, including some elements of senior management staff, for example, are also removed. If not, you worsen the situation by removing an income generator but not completely removing the costs.
It is remarkably common for staff replaced by a more efficient machine not to be let go but relocated within the business. Therefore, the savings on the expensive machine are negated by no change in the businesses labor costs. See the discussion on the Labor Efficiency Ratio elsewhere in this material to measure if you are improving. (see 80/20 Staffing article)
2. Sell down
Secondly, you may be able to sell one of your underperforming competitive segments to one of the other competitors in that space.
Something that for you is not very attractive may be a useful bolt on to their operation.
This can be particularly true if you have customers that they would like to acquire from you and haven't been able to pull away through simply competing with you.
It is common for competitors to buy other businesses for quite high prices.
There are at least 2 reasons for this:
- Adding on your customers gives them increased scale, which allows them to reduce their costs per customer and improve their profit.
- It takes you as a competitor out of the market place, which allows them to improve their price points when they don't have to compete with your price points.
Therefore, it's quite possible that you can make a worthwhile exit sale to a direct competitor in that competitor’s segment.
3. Spin off
Thirdly, you can spin this business off into a separate business.
It's quite possible that some of your competitive segments are poor because they don't get sufficient attention from Head Office or alternatively, they get too much attention from Head Office and can't find their feet themselves.
Spinning the business off into either a wholly owned subsidiary or into a rather more stand-alone operation may allow that segment to find its feet.
If, when you spin it off, you give the new management some equity in the business, they are going to be rather more highly motivated to perform than they would have been when they were buried in your larger business and without an incentive to perform. This is the known MBO (Management Buy Out).
You can retain some measure of control and input by remaining on the Board of Directors of the new entity.
There is a great deal to grasp in this article.
It is important stuff likely to have quite an impact on your business's success.
But nothing will happen unless you buckle down and start to the the analysis outlined above.
While you might argue you have not time right now, unless you can fix some of the problems in you business, you will never have time.
See also the Personal Development Menu for hints on finding more time in your life.
Youtube: Labor Efficiency Ratio (LER) Overview by Petra Post-It Note University. In this 22-minute presentation, Coach Rob Simons takes the viewer through a detailed description of the Labor Efficiency Ratio (LER) - link.