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The Pareto Principle for Profit Improvement

The Pareto Principle (also known as the 80-20 rule) is named after an Italian economist named Vilfredo Pareto. While this principle can apply to many areas of business, let’s look at two possible applications in your small business:

Possibility 1) 80% of your profits come from the top 20% of your customer base.

Possibility 2) 80% of your customer frustrations come from the top 20% most frustrating customers (better known as the bottom 20% of your customer base).

If the second possibility exists in your business, the reality is that your bottom 20% of customers provide you with no profit at all and in fact are likely costing you money!

How do we check this?

We can do a Pareto Analysis on your customer base.  Here’s a simple step by step process:

Step 1) Make a list of your current customers.

Step 2) Determine a ranking system for your customers.  A sample system would be to score each customer from 1 to 5 on the following attributes:

  •      Payment history – 1 for a quick payer to a 5 for a delinquent.
  •      Hassle factor – 1 for never a problem to a 5 for continuous hassle.
  •      Likability – 1 for we really like working with them to a 5 for we hate them.
  •      Value for price fit – Score a 1 if they appreciate and really value what you do for them and to a 5 for no appreciation and less desire to pay for your value.
  •      Risk – Evaluate the business risk of doing business with each customer – 1 is for lowest risk and 5 would be the highest.

The above are just examples. You decide the correct attributes of a good or bad customer.

Step 3) Rank the customers according to the ranking scheme.

Step 4) Consider the top 20% of the customer ranking.  If Pareto was right, the top 20% of your customers are where you make most of your profits. Don’t forget to thank these customers!

Step 5) Review the bottom 20% of the customer ranking. Ask your accountant, bookkeeper or business advisor to help you determine your profit from these customers.

Even though Vilfredo Pareto has been dead for almost 90 years, he might be able to help you improve your profits:  Consider firing or politely discouraging any one of the bottom 20% from being your customers.

Even without applying this principle to your specific business, we know there is not only the potential for profit improvement, there will be quality of life improvement to be enjoyed by you and your employees who won’t have to deal with as many frustrations any more!

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