Businesses typically transform because external triggers and/or internal changes expose critical opportunities or problems that require a shift from the status quo. Some examples are changing customer behaviors, supply shocks, competition, breakthrough technologies, leadership transitions, employee, and stakeholder expectations. As they look to transform, it’s important to step back and take stock of the reason for and the goal of the transformation.
Consider a fairly common example: Company X carries a large product portfolio that grew during boom times with vigorous investment in product development and physical infrastructure, namely plants and DCs. Yet now, those customers have become value-conscious. The plants and DCs are full and terribly busy but the effort they are spending on isn’t translating to higher customer satisfaction, better gross margin, and improved cash flow. The pain gets worse when revenues begin to decline as customers go to competitors. Some of these revenues may be lost to smaller, perhaps nimbler, upstarts that are wooing customers away with tailored customer experiences and faster service.
So what can Company X do? Technology can come to the rescue. I am a big believer in technology-led transformations and digital technology today has come a long way over the last decade and more importantly, it has gotten cheaper to build and adopt. There are more efficient ways to reduce the workload of managing a large number of SKUs, customers, orders, sites, suppliers, high-speed pattern recognition, and classification allowing for more robust predictions. One would say, Company X, should embark on a journey to invest in these technologies either directly or with partners to transform itself completely.
However, is there another approach – a focused way to improve what’s necessary and speed up time to value? As an engineer, I am also a big believer in simplicity which means looking for levers that can deliver most of the value quickly with the least amount of effort.
Can you simplify your business, then transform it to grow your business?
What are the benefits of simplification:
- Focus on what matters most and do fewer things better
- Build agility and responsiveness and uncover innovation opportunities guided by purpose around the core of the business
- Lower upfront costs and faster time to value
Simplification doesn’t just mean cut stuff and keep running what’s left the same way. It’s about focusing your team’s effort, resources, and investment where it’s rewarded with customer value creation.
At a high level, there are 4 steps to iterate through:
- Find the critical few customers and products that create value
- Understand the customers and products here – go deep.
- Orient your strategy and operations to focus on them and outpace your competition.
- Be bold i.e. invest disproportionality
- Be agile in your decision-making and execution
- Build a culture of continuous improvement
- Innovate and expand outward to adjacencies
- Deprioritize and/or rationalize the rest
In this article, we’ll talk about the vital first step.
The first step toward Simplification – 80/20 Principle
In 1906, Vilfredo Pareto discovered in his research that 80% of the wealth in Italy belonged to 20% of the population. Later, an engineer, Joseph Juran applied these ideas to quality management calling it the Pareto Principle and coining the phrase, “the vital few and the useful many”. The Pareto principle, however, extends beyond the factory floor and the realm of defects. It can be observed across many industries: Volkswagen found that roughly 20% of the automobile build combinations were responsible for 80% of the profit margin; Microsoft found that 20% of its software bugs caused 80% of the errors leading to a general simplification of the Power Law relationship observed in businesses viz. Less than 20% of customers or products or SKUs generate 80% profits. Logically, prioritizing our focus on the 20% will have a proportionally large impact on the company’s bottom line.
Applying the 80/20 Principle
80/20 is a hypothesis so you must first test it. I highly recommend starting at the business unit level instead of a function or a single plant or DC. This prevents a less than optimal outcome i.e. improving or enhancing just one part of a system, may not enhance the whole system. Making your commercial organization more efficient won’t fix your revenue issues if your plants are inefficient.
The effort to do this should be minimal as the data should be readily available. You will need a report of customers, the product they buy with the annual sales and profit (Note: you may use contribution profit instead of gross profit). With that, you can rank each product in terms of highest to lowest profit and each customer in the same way. Draw a line where the cumulative profit equals 80% and map the customers to the products they buy and… Voilà! You have a value map of your business.
So, what do we see here? First, if the 80/20 logic holds, 80% of your profits will come from 20% or less of your customers (let’s call them the 80s customers and the rest the 20s customers). Similar behavior will unfold for your products (let’s accordingly dub these 80s products and 20s products). Next, looking at the combination of the customers and products will reveal a 4 quadrant map of the business where:
Quadrant 1 – 80s customers buying 80s products. Delivers ~64% of the total profit. These are the critical few to focus on and to fortify.
Quadrant 2 – 80s customers buying 20s products. Delivers ~16% of the total profit – the necessary evil to manage/optimize and protect, if truly essential, against the competition.
Quadrant 3 – 20s customers buying 80s products. Also delivers ~16% of the total profit but are interested in your 80s products. Appropriately differentiate how you serve and identify growth customers.
Quadrant 4 – 20s customers buying 20s products. Delivers 4% or less of the total profit to be rationalized.
One of the big learnings you may have is that your 80s customers and products are subsidizing your poor performing areas of the business because of the way you allocated costs viz. Customers that are cherry-picking your products or buying retail size quantities at a wholesale price but get allocated distribution costs based on sales value, specialized products, and support for 20s customers (unique Quad 4 products that never took off), process exceptions (special product handling, invoicing) and investments (equipment) for 20s, etc.
A simple, illustrative example of 80/20:
The airline industry probably provides the most visible example of applying the 80/20 intuition. Take any of the well-known international carriers. Frequent fliers, particularly, those that fly a lot, get assigned a status (80s customers?) and earn some sort of status currency that they can use towards upgrades to business or first class (80s products?). Arguably, these customers also get a higher level of service from the moment they check-in (priority check-in) to the moment they board (priority boarding). Even getting a dedicated support line and a note of recognition from the employees they interact with. In other words, the relentless focus on these 80s customers allows the airline to segment, serve, improve and innovate (think credit cards, hotel and car rental partnerships, automatic upgrades, upgrade, or buy with miles, etc.). These innovations and service improvements inspire other customers (Quad 3) to want to qualify for status when they travel, including paying to upgrade to business or first. Ultimately, the opportunistic or price-sensitive traveler (Quad 4) is provided seats at the appropriate competitive price with appropriate service.
Running an airline is far more complicated than a single paragraph so this is definitely a simplified example but note that the airlines do not ignore serving 20s customers and products in other parts of the plane. To be clear, they respect each and every passenger but they clearly maintain a higher level of service and focus for their most loyal customers.
Now imagine what would happen if they managed every customer and every seat equally. This would require a dramatic change to the way they did business including changes to their planes, their check-in to boarding experience, and even the kinds of customers that flew with them.
Lessons for Company X:
Let’s put this into perspective for Company X. By building the Quad chart for the business, Company X can identify the critical few customers and products that require a deeper dive to fundamentally identify their needs and opportunities for their transformation journey. Now, they can combine this focus with the power of technology to aid and assist with rapid decision-making and execution.
- Focus on the critical external signals for demand planning scaled up by an AI capability
- Prioritize what to build and where to stock inventory and how much safety stock to reduce lead times and improve service with optimized working capital utilizing network optimization tools
- Rationalize the portfolio and along with it, pricing and promotion efforts using digital marketing tools
- Consolidate shipments and optimize picking and shipping costs in its warehouses
- Identify key supplier partners to collaborate with to maintain high levels of service for those critical customers
- Tune the focus of innovation or engineering teams, invest capital where it matters.
The common theme is: Focus your teams, resources, and investments on the 80s. Be bold, invest more, move fast.
What next? I have the data
80/20 is a mindset and it’s important to communicate this mindset to your team. This starts at the very top. If the company or business unit’s leadership doesn’t develop this mindset, it will not be supported. This has a direct impact on how the rest of the organization gets shaped and the culture begins to seep in. If accountable leaders are not talking about it and walking the talk, the rest of the company will see it as a fad. I recommend testing this out in 1 or 2 business units or business lines within a business unit – “test, learn, pivot”.
After your leadership team, it will be critical to get the commercial teams on board as they are closest to the customer and may feel they are most impacted. It’s critical to support this change with empathy and with the right behaviors and incentives – “what’s in it for me?”. When you succeed here, you start moving very fast.
Finally, your operations teams need alignment on priorities supported by systems that they rely on. Expect pushback if you have a first in-first out approach or metrics that reward “being busy” over being effective. Explain the change, the “what’s in it for me” question, and invest in the systems/technologies that make the change easy to absorb into the day-to-day work.
Here are some thought starters to build your deployment and change story:
- What problem does my business face today or what opportunities are we missing out on?
- Who and what are our 80s and what is their contribution to this problem or opportunity?
- How are we getting around this problem today and what metrics are we using?
- What will we have to change and how are we going to measure performance?
- What’s in it for you (the employee)?
- How are we going to or what have we done to quickly test and validate the problem/opportunity?
Questions that may come along the way
1. My business is different so I don’t have to do this.
True, the quadrants will look different in terms of profitability and range of products so decisions will be different but if the 80/20 logic holds for your business, why would you leave value on the table or treat your best customers like they were any other?
2. We’re still a start-up so this is not relevant.
Look for symptoms of complexity i.e. too many initiatives, few being completed, too many customers or features, etc. These can affect a startup too and slow you down where speed is supposed to be your biggest ally.
3. Are we putting all our eggs in one basket by taking this approach?
No. This is a great way to assess that risk and take a market-centric approach to optimize the risk and complexity of the business.
I have more questions:
- Reach out to me
- Read about 80/20 and related principles – there are plenty of books (see notes)
- Read about companies like ITW and IDEX that have a long history of using 80/20 as part of their operating models
Recommended Further Reading:
- ‘The 80/20 Principle’ – Richard Koch
- ‘Fewer, Bigger, Bolder: From Mindless Expansion to Focused Growth’ – Sanjay Khosla, Mohanbir Sawhney
- ‘True Profitability’ – Pedro Ferro, Patrick Mossimann
- ‘Think inside the box’ – Tim Nelson
- ‘Waging War on Complexity Costs’ – Stephen Wilson, Andrei Perumal
- ‘The Founder’s Mentality’ – Chris Zook, James Allen