The 80/20 Rule
Few rules are more widely quoted today than the 80/20 Rule (the Pareto’s Principle), which states thing like “80% of your sales come from just 20% of your customer base”.
In this age of relationship marketing, this rule has become an often-heard battle cry to focus our efforts on maintaining the loyalty of customers belonging to the golden 20% that drive most of our business, while spending less effort on the trivial other 80%.
Intuitively, it makes sense. But this marketing interpretation of the 80/20 rule is flawed.
The present understanding of the 80/20 derives in large part from Dr. Joseph Juran, who in the 1940s wrote a wonderful article describing the 80/20 rule’s applicability to industrial quality control. He concluded that the greatest quality gains were to be found in focusing quality assurance efforts on the 20% of all defects that cause 80% of problems. He saw that not all defects were created equal, so it is inefficient to treat them as if they were.
Juran’s work has subsequently been expanded to a wide range of other fields, including marketing, where it has found a home in customer loyalty theory and relationship marketing. While interesting, the direct application of Juran’s work to marketing is not as straightforward as it first appears, and care should be taken when applying it to our marketing practices.
The 80/20 rule as conceived by Juran assumes an equal return on investment for each opportunity. This is not an assumption that typically works in marketing, where the margins on sales vary widely based upon the terms of those sales. Most importantly, the more a customer buys, the more bargaining power they tend to have to drive down the price they pay per item.
For instance, a bar of soap sold through KMart will tend to margin less for its manufacturer than the same bar of soap sold through a small grocery chain, since KMart’s purchasing power enables it to drive a significantly better price per bar of soap than everyone else. This difference in margins means that the gains in volume catering to the golden 20% can come at the cost of a lower profit margin. When those differences are great, it is easy to have situations where the “trivial” 80% of customers are actually more profitable on only 20% of the volume.
This observation lies at the heart of a richer interpretation of the 80/20 rule, which can lead you in many circumstances to do the exact opposite of what a simple Juran-style interpretation of 80/20 would lead us to believe.
An alternative way at looking at 80/20 rule in marketing is as a model for creating economy of scale through selling to a few high-volume customers at near cost, while funding continued overall business growth through selling at higher margins and lower volume to everyone else.
As the high-volume customers drive down prices through leveraged negotiation, a marketer is able to offset the need to appease these powerful buyers by margining well everywhere else in their business, as long as they have an adequate population of low-volume buyers.
In this light, the 80/20 is not always an argument to wash our hands of low-volume customers. It actually is an argument to use a blended profit margin to achieve continued growth and competitiveness without being priced out of the highest-volume deals. Those high-volume deals, while having decreasing returns proportionate to their scale, are critical for a business to achieve the necessary economies of scale to competitively lower overall costs of production and distribution.
In other words, the highest-volume 20% of your customer base will drive profitability through creating efficient scales of business, while the lower 80% will drive profitability through aggressive margins. It is easy to see how these two strategies would work best when they feed off each other’s efforts, rather than working in isolation. Indeed, there are often harsh growth limits for your business set by selling only to the “best” 20% of your customers, or engaging only in low-volume deals.
This is not to say that relationship marketing efforts to keep the loyalty of “golden” 20% should be abandoned; rather, the health of our marketing relationships with other 80% of our customers needs to be equally addressed and certainly not abandoned. The only exception to this general rule is when the margins on high- and low-volume customers are largely identical or random. In those cases, ignoring the 80% is probably a good idea.