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We frequently refer to the 80/20 Rule in Profit Savvy.  It assumes you can spot the best and worse performers among your products, market, staff and customers.  This article explains the simple methodology behind quickly allocating each candidate to a slot in the rankings chart. This Blue Belt

It doesn't matter whether you are looking at products, customers, staff or various markets on a geographical, demographic or channel (e.g. retail, online) basis.  The method is always the same.

For this demonstration, let's assume we are selling widgets of various colors and we want to better understand the value each colour of widget contributes to the business.

Method

In a spreadsheet:

  1. List each of your product groups in column 1.
  2. Their sales income in  column 2.
  3. Their purchase price in column 3.
  4. Known direct costs, like sales, in column 4.
  5. In the fifth column, calculate the profitability by the formula [sales income (2) minus purchase price (3) minus direct costs (4)] .
  6. In column six, put the profit returned for each product (column 5) divided by the total profit.  This gives the share of the profit contributed by each product.

To see if you have this right, put $100 into the sales income, $50 into purchase cost, and $10 into direct costs.  Column five will now have $100-$50-$10 giving $40.  Column six will have $40/$100 giving 40%.  See the table below for further examples.

Using the sorting facility in your spreadsheet, sort all your products by their return on sales, so that the highest returning group is at the top in the first line of your spreadsheet.

In column seven, put in a formula to calculate the cumulative amount of the sales for each of the products as they are listed.  The cumulative amount is calculated as the sales of any particular row plus the sales of all the rows beforehand.  The formula in row 1 of column 7  is taken from the top of column 6.  In row 2 it is column 6 + the previous row in column 7; and so on

 

1

2

3

4

5

6

7

Product

Sales

Purchase

Direct

Profit

Return

Cumulative

Blue widgets

100

50

10

40

50%

50%

Red widgets

62

20

12

30

37%

87%

Yellow Widgets

115

80

15

20

25%

112%

Brown widgets

60

50

20

-10

-12%

100%

Total

 

 

 

80

 

 

 

In this example, we have intentionally put in a Brown Widget product that loses money.  This might be more common than you think when you do finally break your products down this way.

Arranging your data this way will very quickly indicate where your 80/20 break-up is. 

In this example it is roughly after the first two products in the tableYellow widgets only contribute a quarter of your profit and brown widgets actually cost you money.

On face value, you would dump brown widgets and give serious thought to dumping yellow. 

Alternatively, you could reduce the cost of poor performers, like our yellow widgets, by (for example) reducing their direct selling costs by only selling on-line rather than with a field sales force.  Dropping selling costs, boosts profits and possibly puts it back in the top 20% of performers.

Pareto chart

If you are a spreadsheet virtuoso, you could actually graph this information in MS Excel's Pareto Chart option, which shows the products by their contribution to profitability on one axis and the cumulative figures on another axis.  Pareto discovered the 80/20 Rule.

You can see how to do this in the YouTube video "Create a Pareto Chart".

 

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