80:20 rule – Pareto principle

The marketing axiom that “80% of your business comes from 20% of your customers.” is also known as “Pareto’s rule”.
If means that, theoretically, if you can keep just 20% of your best customers, you would still earn 80% of your revenue. Why? Because these customers are mostly loyal and keep coming back.
My colleague and business partner Daniel had a server-hosting business. At lunch, he once complained that some customers delay their payments and that he was unsure whether he should prolong his contracts with them or not. Together with my friend Jan, we took his data on revenue, costs and past-due payments, and applied the Pareto Rule. With few exceptions, Daniel could cut off the most problematic customers. His decision was also supported by data from helpdesk system, because there were significant costs connected with each customer-care call. Notoriously complaining and non-paying clients were the first candidates. We were so amazed by the subsequent profit growth that we founded Futurelytics together! That has enabled us to apply similar, though more advanced, logic on many more businesses since then.
Tim Ferris promotes usage of the 80:20 rule in his book “4-hour work week”. Why? Because it simply works…
However the key ratio isn’t always exactly 80:20 for everybody. It can be 73:17 as well as 56:33. Different businesses have different ratios.

Our team took the effort to find-out what is that ratio for particular businesses. We used so called “gains-chart” that sorts customers by their value and displays it as a cumulative curve. You can then see how much total value give you your best 20% of customers. However you may want to also determine the “optimal cut” between “VIP” customers and “other” customers. The point where the subsequent customer delivers lower value than the given one is the break-even. Following example shows that approx. 62.5% of value is due to 20% of customers. At the same time we can conclude that there are approx. 13% VIP customers that give the company about 58% of revenue.

RFM Gains Chart
This model lets us generalize the problem over any analyzed business. Customer value needn’t be just total revenue or profit. There are metrics that help you determine it much more accurately with regard to a predictable, future customer value. These are average purchase frequency and mainly last purchase’s recency. When you blend those two with total revenue – or even better – profit, you will get a customer “RFM score”.

Being able to determine the right group of VIP customers is essential for every business. There are though also other customer segments that must not be forgotten. They are discussed in my book SIMPLE ANALYTICS TO TURN YOUR DATA INTO A GOLDMINE.

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