Management Secrets: 80/20 Rule & Creating Business Segments

“A man who knows the price of everything and the value of nothing” was Oscar Wilde’s definition of a cynic.   Creating the distinction between what Warren Buffet calls “intrinsic value” and simply the price tab makes for the beginning of both a smart manager and an astute investor.

“A man who knows the price of everything and the value of nothing” was Oscar Wilde’s definition of a cynic.   Creating the distinction between what Warren Buffet calls “intrinsic value” and simply the price tab makes for the beginning of both a smart manager and an astute investor.

One of the most wonderful insights about business that will make you look like management wizard to your boss is the application of the 80/20 rule.

80 percent of the value of any activity is likely to come from 20 percent of the inputs. For instance, 80% of your company’s turnover comes from 20% of the customers. 

Who are these, what do they want, how can you strengthen the working relationship are points you might want to act on.  80% of the value you generate at work is likely to come from 20% of your time.

Knowing what tasks this is, will make you a more productive manager. Let’s take this line of thinking to the next step and apply it your business.

Look at the your company’s financial statements, on the income and expenses page you will see revenues, a break-down of expenses, and a bottom line profit before interest and tax (PBIT).

It’s not uncommon to find companies revenues consistently going up and profitability lagging.  What’s going on?  No one took the time to ask what business are we in, and with who – and put the results under a microscope.

If you ask senior management to tell you which business segments they are in to generate the stated turnover, they will give a vague definition of say four clusters – four lines of business.

Yet, with some probing it is not uncommon to find that four clusters are really, for example,  10 distinct business segments. 

What do we mean by business segment?  Anything that makes up a separate product, service or activity. 

A business segment is created any time you are dealing with one group of customers, rather that another, or when the main competitors are significantly different.   

Try breaking your business down to segments and examine the profitability per segment – you will likely be in for a shock.

Lines of business you thought were profitable may actually lose money, and lines you thought were lagging may be  cash cows, or at least cash goats.  

Try and estimate segment profitability as best you can with the accounting information available,  for instance, sales per segment and the gross margin (sales less cost of goods).

The trick is to make an allocation of all the business’s overall fixed and variable costs to each of your newly recognised business segments.

After some number crunching you will have a rough estimate on business segments return on sales and ideally return on capital employed. 

Assessing profitability per segment and applying the 80/20 rule will be a wise first step on the journey to  creating a profitable  business strategy.

Don’t feel bad that no one recognised this before, chalk it up to experience. As Oscar Wilde remarked, “experience is the name everyone gives to their mistakes”.

The author is a management consultant working in Rwanda 

dja@abbott.co.ke

 

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