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Where Are You With The Pareto Principle?


3/9/2011
By Gerald Wheelus

In any business, including ours, it’s used to identify where our customers come from.
 
Gerald Wheelus
The 80/20 rule — you’ve probably heard of it. It’s also called the Pareto Principle, named for Vilfredo Pareto, an Italian economist, engineer, sociologist and philosopher, who observed that 80 percent of the land in his country was owned by 20 percent of the people.

In any business, including ours, it’s used to identify where our customers come from. In some cases, we apply the 80/20 rule to those who work around us. Either way, “The Pareto Principle” is considered the law of the vital few: For many events, 80 percent of the effects come from 20 percent of the effort.

When we look at parts stores, we may not always see the rule at work because it’s buried a bit. But our business is built in market segments that include walk-in trade, dealer business, possibly farming, industrial, etc.

Consider a scenario where you may have $20,000 in dealer business. If you have 20 customers that comprise that 20K, there are four or five customers who make 80 percent of it. So, with four to five customers being 20 percent to 25 percent of your 20 core customers — they will account for approximately 16K of the business you had in this hypothetical month.
This is important for many reasons because we have to know what customers need to be top priority.

Unfortunately, we have to break our customers into priorities of service levels. We don’t like to admit that some customers are favored over others but, here in the real world, they are. Now that we have acknowledged we favor certain customers, we have to prioritize them as such. Since we’ve determined in the hypothetical scenario above that four or five of the 20 customers will make up 80 percent of the total sales volume, we have to cater to those four or five top customers. That is the simplicity that Pareto proved in his business model.

While the Pareto rule can help establish what customers we currently service, it also helps evaluate whom they are buying from. It also can help to evaluate what those customers are buying, or maybe more importantly, not buying from us. It would be a safe bet that anyone of those top five customers in the above scenario buys a specific market segment from us and 80 percent of their purchases come from that market segment (i.e.. undercar, underhood, heavy duty). That is why we have to print the reports and look at them and evaluate the circumstances. Once we are able to identify these things, we can evaluate these three things in order to gain a better understanding of what we can do to grow.

Growth has to come from one of two places — existing customers or new business. New business is the hardest to earn and is usually the most volatile and we have to be very careful that we do not lose focus of the captive customers who are supporting us already. For the sake of this scenario, we are going to consider only the dealer trade as it relates to the automotive industry and exclude the walk-in trade, fleet trade or heavy duty.  

Evaluation 1, Who are our customers?
We have already established that five of our top 20 customers contribute 80 percent of our overall sales volume. Now, of that five customers or 20 percent, are we getting all the sales we can get from them? Realistically, all we can get is 80 percent of those sales. Since those captive customers are at a peak buying level, we have to try to earn new
business from somewhere.

So we have to consider the other 80 percent of the customers whom we feel have not reached their peak buying potential. This scenario leaves 15 customers for us to target. Of those 15, we can realistically expect 20 percent of them to switch over to us. So, in this case we now have a minimum of three potential new customers. Obviously, not all markets are the same and potential can vary, but Pareto’s rule still applies.

Evaluation 2, Whom are they buying from? Since we now know who the customers are, we now need to find out where they are buying from. This effort may not be the easiest. But customers will almost always tell you were they are buying from. Again, we have narrowed our newest targets down to 15. It would be safe to say that of the 15 left in this scenario, 80 percent of them are buying from our competition (they’re aren’t buying from us, right?) Rarely does a customer buy equally from everyone, so we must determine who a potential new customer is buying from primarily. It would be safe to say that 80 percent of that customer’s purchases are coming from 20 percent of the suppliers available in the market area. In bigger markets, we may find we are third or lower on a list of suppliers that the customer is buying from, so our obvious goal is to move up that list to the No. 1 spot.

Evaluation 3, What are they buying? This will help you identify your stock so you know what mix of merchandise you need in the store. We have now determined who the customers are, who they are buying from and now we have to consider what they are going to buy, be it undercar, underhood, etc.

It is not always easy to determine this but, if we can, it will most likely come from just 20 percent of the lines we sell in the store. Consider the scenario: we have narrowed our search down to three new target customers. We may choose one over the other two to really target hard because they might be an alignment shop that we know we could service well because we already service another in the area and cover at least 80 percent of their needs. This is where knowing our own strengths and weaknesses will pay off and knowing the 80/20 rule again will help.

We can stretch the Pareto Principle to meet whatever need we have. It’s not a sure fit for everything, but it would be safe to say that 80 percent of everything we do falls under the 80/20 rule.














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