Over a hundred years ago an Italian economist made a discovery while in his garden. Vilfredo Pareto noticed on a pleasant 1906 afternoon that 20% of the pea pods in his garden produced 80% of his pea production. His interest piqued, Pareto wanted to know if this 80/20 ratio applied to other areas, including business. In every place he looked the ratio held. 80% of results came from 20% of the inputs.
Today we call this the Pareto Principle or the 80/20 Principle. The ratio isn’t perfect, but more of an approximation, somewhere around 4 to 1 or 5 to 1. And it happens everywhere, not just in business or an Italian’s garden! Think about it. You wear 20% of your clothes 80% of the time; use 20% of your home or apartment 80% of the time; eat the same food 80% of the time.
Illinois Tool Works is a large public corporation that has turned the 80/20 Principle into a profitable business plan. ITW buys smaller competitors on a regular basis and then sends in their teams to ramp up profitability by firing clients! Sort of. The 80/20 Principle says 80% of profits come from 20% of clients. Yup. It does. I ran the numbers in my own office. A small list of my clients brings in the bulk of profits. And ITW capitalizes on this fact to improve profitability in companies they purchase.
Think of your personal life. You spend 80% of your waking hours doing the same 20% of activities. If a normal day includes 20 activities, about 80% of the time will be spent on four of those activities.
The Other Side
At first glance the 80/20 Principle looks like a cool way to look at the world. Turn the principle upside-down and you will find ways to game the system to your advantage. If 80% of profit comes from 20% of clients, then 20% of your profits come from the remaining 80% of clients. Yikes. You could actually cut your workload 80% and only lose 20% of your profits!
ITW takes the 80/20 Principle to the extreme. If you ever read their annual report you will see the 80/20 Principle front and center.
The ITW teams don’t just fire 80% of the clients, employees, et cetera. They realize the way the purchased company is organized is the real problem. Dropping 80% of the clients could cause a reputational problem for ITW. Rather than starting a massive firing program of clients and employees, ITW sets up distributors which then handle the 80% least profitable clients. Now ITW has one large distributor buying from them, reducing cost and increasing profitability.
The added efficiencies mean employees don’t face layoffs. Production is now focused and sales tend to rise rapidly for a few years in the new division of ITW until a new higher level of sales is reached. Clients have a dedicated distributor to work with so they are happy. The distributor is more profitable because they focus on their narrow niche.
The process is more involved than a short intro to a blog post can detail. What we have learned so far, however, can help us in areas of work, business, home, and personal life. Let’s explore.
You Work Too Hard
Your workday at the office or in your business is filled with interruptions, phone calls, and emails. These, and a few other things, consume 80% of your time yet only generate 20% of the profits or results. Applying the 80/20 Principle with a butcher knife would mean ditching all this non-productive work which could also cause problems with the profitable 20% of your time. Time to put the butcher knife away.
Working for a company limits how you handle the 80% of your time issues. You still have the ability to manage your time more effectively within the framework of employer demands. Writing endless memos, checking emails all day rather than at designated times, and idle chit-chat with coworkers can waste most of your day. And the boss notices more than you think she does.
It gets worse if you own a business. Your bad time management skills spill over into the work habits of employees. 20% of employees bring in the bulk of the company’s revenues and profits. You can either fire the employee or change the parameters they work in.
Clients are the same. 20% of clients will consume 80% of your time and they are not the 20% most profitable clients either. Time for a plan.
I am not a big fan of outsourcing. A recent post published here on outsourcing was only a first step. Outsourcing has too many problems so I prefer alternatives. A follow-up post to come in the next few months will outline a network of strategic alliances I have created to improve efficiency while serving new clients. The network I am building will be available for anyone to use, including other accounting firms.
There are two ways to build strategic alliances: with existing firms or by setting up a new firm. ITW is a master at setting up new distributors and selling the bulk of clients to these new distributors or existing companies. Small business owners will usually be better served by working with existing companies.
My practice started as Tax Prep & Services. We did taxes. Period. Eventually a few payroll and bookkeeping clients showed up. Regular tax clients needed the extra services and we obliged. But I was still a tax firm. Then the write-up work exploded. We did good work until so much work walked in the door it started hurting quality. We lost focus by offering too many services to clients. Still, all the services we provided are provided by accounting firms. The only way to provide large accounting firm services while retaining a small firm feel is with strategic alliances.
The company name was changed to Tax Prep & Accounting Services. How original. It reflected our newfound attention on the accounting side of the equation. What I really did was lose focus. I’m a tax guy. Now I was the jack-of-all-trades and master-of-none. It started to show.
Finding and keeping employees that could do a bit of everything was impossible. Everything suffered from quality to productivity to profitability. Enter the strategic alliance.
Like ITW I started to forge alliances with experts in narrow portions of the industry. The core of my practice will remain, including consulting and speaking engagements. All the sideline stuff will be handled by a strategic alliance partner. Low profit activities will be managed by a third party with economies of scale. Better yet, the partner generally has increasing economies of scale. This is where each new client costs less to serve than the one before at an increasing rate. The more clients, the cheaper it is to serve them and at a higher level of quality.
And the remaining core tax business will have certain limited economies of scale too. Under a strategic alliance my tax clients will also be the client of other firms within the network for payroll and other services.
Payroll services were never very profitable in my office. By partnering instead of outsourcing, our clients are better served. My firm gets a residual income which is almost 100% profit. Our workload drops massively freeing time to focus on the core business and we finally turn a profit on that dreaded payroll department. Best of all, the client receives a much better experience and service. The room is filled with winners.
Time to get Personal
The 80/20 Principle is fine and dandy for the business community, but how does it apply to our personal lives?
Optimizing your duties at home reduces stress and opens more time to spend with your significant other and children. The bulk of our day at home is filled with TV and surfing the internet, including social media.
Time wasted on meaningless activities eats away at relationships, happiness, and joy. Living the good life requires attention on the things which matter most. Track a normal day and I think you will find around 80% of your activities are not giving you what you want or even bringing happiness. Hours playing a video game is a way to distract yourself or to avoid doing something meaningful. It certainly is not a happiness producing activity once more than a token amount of time is spent playing the games. The same goes for social media, email, and web surfing. How many cute cat pictures do you need to see before it is no longer cute or funny?
And now we get to your stuff. You can downsize and minimize easily. You haven’t used 80% of your stuff since Bush was in office. The old shoes need to go. Nobody needs 38 pairs of pants. Nobody. Less stuff means less stress which means more joy and happiness in life.
Talking about joy, it is the Christmas season as I write this. Nowhere else is the 80/20 Principle more in effect. We spend 80% of our time running to Christmas parties, shopping, and running around getting all the stuff we need to get done before Christmas. Don’t forget about football. Your team could make the playoffs and your watching the game might help their chances. Life is hectic around the holidays. Never enough time to get it all done.
At least you have the 20%: the time you spend with your son and daughter, wife or husband, or parents, if they are still alive. The warm feeling of time together with friends as a gentle snow drifts down outside is so satisfying. There is no feeling like it in the world. It boggles the mind why you only spend 20% of your time doing what makes you happiest.