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Kindle Notes & Highlights
by
Richard Koch
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January 7 - February 20, 2025
For every step in your business process, ask yourself if it adds value or provides essential support. If it does neither, it’s waste. Cut it. [This is] the 80/20 rule, revisited: You can eliminate 80 percent of the waste by spending only 20 percent of what it would cost you to get rid of 100 percent of the waste. Go for the quick gain now.3
THE SECOND 80/20 WAVE: THE INFORMATION REVOLUTION
The business world has long abided by the 80/20 rule. It’s especially true for software, where 80 percent of a product’s uses take advantage of only 20 percent of its capabilities. That means that most of us pay for what we don’t want or need.
THE 80/20 PRINCIPLE IS STILL THE BEST-KEPT BUSINESS SECRET
Over time, 80 percent of the market will tend to be supplied by 20 percent or fewer of the suppliers, who will normally also be more profitable.
It will tend to be true, therefore, that 80 percent of surpluses or profits are generated by 20 percent of segments and by 20 percent of customers and by 20 percent of products. The most profitable segments will tend to (but will not always) be where the firm enjoys the highest market shares and where the firm has the most loyal customers (loyalty being defined by being longstanding and least likely to defect to competitors).
It is this lack of balance, rather than a notional equilibrium, that characterizes all economic activity. Apparently small differences create large consequences. A product has to be only 10 percent better value than that of a competing product to generate a sales difference of 50 percent and a profit difference of 100 percent.
Three action implications
One implication of the 80/20 theory of firms is that successful firms operate in markets where it is possible for that firm to generate the ...
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A second practical implication for all firms is that it is always possible to raise the economic surplus, usually by a large degree, by focusing only on those market and customer segments where the largest surpluses are currently being generated.
A third corollary is that it is possible for every corporation to raise the level of surplus by reducing the inequality of output and reward within the firm. This can be done by identifying the parts of the firm (people, factories, sales offices, overhead units, countries) that generate the highest surpluses and reinforcing these, giving them more power and resources; and, conversely, identifying the resources generating low or negative surpluses, facilitating dramatic improvements and, if these are not forthcoming, stopping the expenditure on these resources.
LOOK FOR “IRREGULAR” INSIGHTS FROM THE 80/20 PRINCIPLE
Identify lucky streaks
The art of using the 80/20 Principle is to identify which way the grain of reality is currently running and to exploit that as much as possible.
If you can identify where your firm is getting back more than it is putting in, you can up the stakes and make a killing. Similarly, if you can work out where your firm is getting back much less than it is investing, you can cut your losses.
HOW COMPANIES CAN USE THE 80/20 PRINCIPLE TO RAISE PROFITS
WHY YOUR STRATEGY IS WRONG
WHERE ARE YOU MAKING THE MOST MONEY?
SEGMENTATION IS THE KEY TO UNDERSTANDING AND DRIVING UP PROFITABILITY
What is a competitive segment?
A competitive segment is a part of your business where you face a different competitor or different competitive dynamics.
Do you face a different main competitor in this part of your business compared to the rest of it? If the answer is yes, then that part of the business is a separate competitive segment (or simply segment for short).
Do you and your competitor have the same ratio of sales or market share in the two areas, or are they relatively stronger in one area and you relatively stronger in another?
Thinking about competitors puts you straight on to the key business splits
DON’T TAKE 80/20 ANALYSIS TO SIMPLISTIC CONCLUSIONS
Segment 13 in the above example helps to illustrate the point that 80/20 Analysis of profits does not give us all the right answers. The analysis is bound to be a snapshot at a point in time and cannot (to start with) provide a picture of the trend or of forces that could change profitability. Profitability analysis of the 80/20 type is a necessary but not a sufficient condition of good strategy.
80/20 AS A GUIDE TO THE FUTURE—DEVELOPING YOUR FIRM INTO A DIFFERENT ANIMAL
Innovation is the name of the game; it is absolutely crucial to future competitive advantage.
80 percent of value perceived by customers relates to 20 percent of what an organization does. What is that 20 percent in your case? What is stopping you doing more of it? What is preventing you from “making” an even more extreme version of that 20 percent?
80 percent of the benefit from any product or service can be provided at 20 percent of the cost. Many consumers would buy a stripped-down, very cheap product. Is anyone providing it in your industry?
Why do you need people?
Every few years a new competitor, such as Ikea in furniture, proves that there is new life in the very old idea of self-service.
Why do we insist on using people to do things that machines can do much more cheaply? When will airlines start to use robots to serve you? Most people prefer humans, but machines are more reliable and much cheaper. Machines may give 80 percent of the benefit at 20 percent of the cost.
CONCLUSION
The 80/20 Principle suggests that your strategy is wrong. If you make most of your money out of a small part of your activity, you should turn your company upside down and concentrate your efforts on multiplying this small part.
SIMPLE IS BEAUTIFUL
Few people stop to ask why the unprofitable business is so bad. Even fewer stop to think whether you could in practice, as well as in theory, have a business solely composed of the most profitable chunks and get rid of 80 percent of the overhead.
SIMPLE IS BEAUTIFUL EXPLAINS THE 80/20 PRINCIPLE
A recent careful study of 39 middle-sized German companies, led by Gunter Rommel,2 found that only one characteristic differentiated the winners from the less successful firms: simplicity. The winners sold a narrower range of products to fewer customers and also had fewer suppliers. The study concludes that a simple organization was best at selling complicated products.
Where a business is dominant in its narrowly defined niche, it is likely to make several times the returns earned in niches where one faces a dominant competitor
Parts of the business that are mature and simple can be amazingly profitable. Cutting the number of products, customers, and suppliers usually leads to higher profits, partly because you can have the luxury of just focusing on the most profitable activities and customers, but partly also because the costs of complexity—in the form of overheads and management—can be slashed.
Outsourcing is a terrific way to cut complexity and costs.
Simplicity raises prices as well as lowering costs.
CONTRIBUTION TO OVERHEAD: ONE OF THE LAMEST EXCUSES FOR INACTION
The need for overhead coverage from unprofitable segments can disappear pretty quickly.
The less profitable segments can sometimes be sold, with or without their overheads, and always be closed. (Do not listen to accountants who bleat about “exit costs”; a lot of these are just numbers on a page with no cash cost. Even where there is a cash cost, there is normally a very quick payback, one that will be much quicker, because of the value of simplicity, than the bean counters will ever tell you.)
A third option, often the most profitable, is to harvest these segments, deliberately losing market share. You let go of the less profitable customers and products, cut off most support and sales effort, raise prices, and allow sales to decline at 5–20 percent while you laugh all the way to the bank.
REDUCING COMPLEXITY AT CORNING
In 1992 the U.S. business was doing badly and the next year the German market fell sharply. Instead of panicking, the Corning executives took a long, hard look at the profitability of all their products.
By eliminating low-volume, unprofitable products, which contributed little to revenues and negative amounts of profit, engineering capacity was reduced by 25 percent.
