What is 80-20 Rule
The 80-20 rule is a business rule of thumb that states that 80% of outcomes can be attributed to 20% of all causes for a given event. In business, the 80-20 rule is often used to point out that 80% of a company's revenue is generated by 20% of its total customers. Therefore, the rule is used to help managers identify and determine which operating factors are most important and should receive the most attention based on an efficient use of resources.
The Pareto Principle (80-20 Rule)
BREAKING DOWN 80-20 Rule
The 80-20 rule is also known as the Pareto principle, the principle of factor sparsity and the law of the vital few. At its core, the 80-20 rule is a statistical distribution of data that says that 80% of a specific event can be explained by 20% of the total observations.
The 80-20 rule is frequently used in business, but it has been applied to a wide variety of subjects, such as wealth distribution, personal finance, spending habits, and even infidelity in personal relationships.
The 80-20 rule was first used in macroeconomics to describe the distribution of wealth in Italy in the early 20th century. It was introduced in 1906 by Italian economist Vilfredo Pareto, best known for the concepts of Pareto efficiency or Pareto optimality. Pareto noticed that 20% of the pea pods in his garden were responsible for 80% of the peas. Pareto then expanded this principle to macroeconomics by showing that 80% of the wealth in Italy was owned by 20% of the population.
Joseph Juran, a prominent figure in the study of management techniques and principles, expanded the 80-20 rule to apply to business production methods. In the 1940s, Juran applied the 80-20 rule specifically to quality control for business production by showing that 20% of defects in production were responsible for 80% of problems. He coined this phenomenon "the vital few and the trivial many."
Because 80% of the consequences stemmed from 20% of the causes, focusing on the critical 20% of causes allowed for more effective quality control and a better use of resources. Juran set forth these principles in his "Quality Control Handbook." The first edition was published in 1951, and the publication is now considered a classic in management theory. After World War II, Juran was invited to Japan to give a series of lectures on quality control, which are cited as having had a major impact on Japan's post-war economy.
That 80-20 rule has since been expanded to more general uses in business. For example, a company may find that 80% of its sales come from 20% of its customers. A company can increase its sales by focusing on the 20% of customers who bring in the majority of the revenue. Also, 20% of a company’s employees may be responsible for 80% of the output. The company can then focus on rewarding the most productive employees.
The 80-20 rule is meant to express a philosophy about identifying inputs. It is not a hard-and-fast mathematical law, even though it is often interpreted that way.
It's just coincidence that 80% and 20% happen to equal 100% in the 80-20 rule. Inputs and outputs represent different units, so the percentage of inputs and outputs does not have to equal 100%. One might observe that, for a given phenomenon, 74% of the output comes from 35% of the inputs. This is entirely plausible and valid, even though 35% plus 74% equals 109%. The underlying principle suggests that certain inputs should be focused on more than others.
There are many misinterpretations of the 80-20 rule. Some result from the coincidental 100% sum. Some result from a logical fallacy, namely that if 20% of inputs are most important, then the other 80% must be unimportant.
The actual implied application of the 80-20 rule is to focus on identifying the inputs with the most potential productivity and pursuing those causes first. For example, a student should try to identify which parts of a textbook are going to create the most benefit for an upcoming exam and focus on those first. That doesn't imply that the student should ignore the other parts of the textbook.
Practical Application of the 80-20 Rule
As it applies to business management, the 80-20 rule holds that 20% of the time spent in a certain area of a business creates 80% of that business's results. This ratio can help businesses become more efficient. By identifying and focusing more time on the most important areas, businesses can achieve higher growth and better results.
If a company can identify its highest-spending customers, for instance, it can effectively market to them to retain existing customers and acquire similar consumers. Therefore, companies should dissect their revenues and understand who makes up their top 20% of customers.
From there, it's been found that the top 4% of a customer base accounts for 64% of total sales, meaning that the more granular a company can get in its analysis, the more accurate the understanding of its customers becomes. This allows companies to launch targeted marketing campaigns aimed at resonating with the most impactful consumers.
Managers must make decisions about how to allocate scarce resources – time, finances, labor and capital equipment, among others. The 80-20 rule suggests that it's important for managers to understand which inputs produce the greatest results.
As mentioned, the 80-20 rule doesn't mean the exact 80% and 20% proportions are necessarily constant in every case. If the manager of a financial advisory firm knows that 70% of the firm's revenue comes from 10% of its clients, then the firm should focus its efforts on those clients first and foremost. That is the most efficient use of resources. It's a matter of opportunity cost, in other words.
The studied causes and effects don't have to be revenue producers. For instance, a manager might know that 80% of his department's computer crashes come from just a handful of bugs; so, he should focus the IT department on fixing those bugs first.
However, the 80-20 rule is like the proverbial half full or half empty glass. That is, the rule works both ways, depending on the manager’s focus.
Applying the rule to a company’s product line tells a manager that 80% of the company’s sales volume is attributable to only 20% of the products in the product line. If those products are stored in a warehouse as inventory, then that superstar 20% of the product line should occupy 80% of the warehouse space.
Using the 80-20 rule to evaluate employees, it suggests that 80% of a company’s production is the result of the efforts of only 20% of its employees. But it could also show the manager that 80% of all human resource problems are caused by just 20% of the employees.
Regarding a company’s revenue, the rule would indicate that 80% of the revenue comes from 20% of the company's customers. Conversely, the rule could also tell managers that 80% of customer complaints come from 20% of the customers. The rule will not tell managers whether the revenue-generating customers are the same as the complaining customers. But since both are only 20% of the customer list, this narrowed focus makes it easier to target those customers who are truly influential, which is the real lesson of the 80-20 rule.
The Historical Validity of the 80-20 Rule
While there is a lack of scientifically stringent statistical analysis either proving or disproving the validity of the 80-20 rule, numerous internal business analyses, and much anecdotal evidence exists to support the rule as being essentially valid, if not numerically accurate.
The basic assumption that underlies this rule is that things are typically distributed unevenly in life. As it relates to business performance, the 80-20 rule proposes that 80% of revenues come from 20% of customers. Regarding investing, the rule suggests 80% of all profits come from 20% of investments. In broad economic theory, the rule refers to the fact that a small percentage of the population owns a large percentage of an economy's financial assets.
For example, the 80-20 rule in economics refers to the fact that 80% of a country's wealth is usually controlled by 20% of its population, although this can sometimes be explained by the Gini index. In June 2016, Nigeria was found to have roughly this distribution of wealth within its country's borders. The minimum annual income needed to sustain a living in Nigeria was $1,000, yet more than 74% of the population lived below this poverty level. This distribution came after the country's population grew by 12% while its GDP rose by 54% from 2010 to 2014. However, the allocation of the increased wealth was not even, and it exacerbated the income inequality, thus adding to the Pareto principle.
Six Sigma and other business management strategies have incorporated the principle into their designs for increased business efficiency. Analysis of performance results of salespeople across a wide spectrum of businesses also supports the 80-20 rule.
The principle appears valid simply from a basic logical analysis. Obviously, not all efforts in any endeavor will be equally effective. It is logical to deduce that, from all the different efforts made toward achieving the desired end, less than half of them will eventually be responsible for more than half of the total results.