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Don’t you just love those “aha” moments in life?  Those experiences where you learn something and the world just makes more sense?  I remember sitting in Gary Loveman’s last class before he joined Harrah’s over a decade ago.  Before that class I had heard of the 80-20 rule, but hadn’t really internalized its meaning.  Understanding this principle has been the single most important discovery in my career.

The Pareto Principle (aka the 80-20 Rule, the Law of the Vital Few)

Italian economist Vilfredo Pareto developed what is now known as the 80-20 Rule after he discovered that 20% of the Italian population accounted for over 80% of the wealth.  He later found that the rule applied for many other economies (and still does, see Table below from Wikipedia).  

Source: United Nations Development Program. 1992 Human Development Report

Back to School.

It turns out that this statistical phenomenon applies to much more than wealth distribution.  The realization came for me when Professor Loveman explained how to use the Pareto Principle to shape business strategy.  I believe the specific case was Harrah’s, where he is now CEO and was a consultant at that time.  

First you segment your customers into some number of groups.  Let’s say five groups based on revenue per year (although you can pick whatever value suits your fancy).  Next find out what percent of revenue your top 20% customers account for, the next 20%, and so on.  You will likely find that the distribution is a power law.  It may not be exactly 80-20 — actually, it’s often far more skewed.

Now find out why those customers are so loyal.  Call them and find out what separates the top segment from the other segments.  If you have multiple products, do they buy certain products more than others?  Use certain features more than others?  Where do they come from and can you tune your marketing to find more customers like your best customers?  Does your analytics effort measure overall metrics as well as the health of your business by segment?

Another big learning was that, for most companies, the average cost of moving a customer from the second most loyal to the most loyal category was extremely small while the cost of going from a new customer to the most loyal customer was often a money losing proposition.  That is, the costs of acquisition exceed lifetime value, on average.  Most companies focus on customer acquisition way too much!  Even very early stage businesses are best served by having evangelists amongst their early adopters.

Other applications.

While I was working at my first startup, an extremely talented marketer from Goodby, Silverstein suggested that I read Eating the Big Fish.  It was a fun read and my takeaway was that positioning is really about finding the message that resonates with that top 20% of your customers.  Most people try to communicate a general message to all potential customers and have limited appetite for negative feedback.  If you have hundreds of millions to fuel your marketing efforts and play in a mature industry, pursuing a broad generic message may be the right thing for you.  But if not, you will clearly get the best bang for your marketing (and PR) buck by honing your message for your best customers.  And don’t forget to chug some Pepto Bismol, because you may ruffle a few feathers along the way.  Just focus on getting the message through to your best customers.

Years later I was working on a large acquisition (the acquisition didn’t go through).  The target had hundreds of customers with extensive contracts.  Our law firm evaluated each contract with equal vigor.  I discovered that the top 10 customers (of several hundred) accounted for over 80% of revenue.  So I read just ten contracts and found some very bad stuff in those contracts that the law firm missed.  Think about the psychology of sales people in organizations – it’s not worth breaking the rules for small deals.  But when you’re talking about millions of dollars in commissions and making a quarter, well rules are made to be broken, right?

And in many companies [certainly large companies] 20% of the employees create a disproportionate amount of the value.  While this is so obvious to so many, why aren’t salaries and bonuses distributed in the same way?  Why do HR professionals tell executives that everything is fine because we only have 15% of our workforce turning over each year of their own volition, which is only slightly up from years past?  Don’t you really want to know what’s happening to your top performers?  

The Long Tail.

There are some cases where using this thinking can get you into trouble.  Chris Anderson did a great job in The Long Tail of describing how the 80-20 Rule can get you into trouble.  With that caveat in mind, many business leaders in many functions would be well served understanding how to put the Pareto Principle to work.