Which is better a $10,000 or $40,000 return for the same investment?
In the past, there have been ideas that were ahead of their time. So far ahead, that they were quickly forgotten. Then “re-discovered” decades later. An example would be Chaos Theory (1969) and the Pareto Principle (1941). At their core, both these concepts have their roots in the work of Vilfredo Pareto who first pointed out the 80/20 correlations in 1896. In 1941, Joseph Juran described the rule saying that “…80% of problems are caused by only 20% of causes…”. This has led to business axioms like:
- 80% of Sales are made by only 20% of the sales team.
- 80% of company purchases are made by only 20% of customers.
Let me illustrate with a quick example:
Let’s say Miko owns a manufacturing business. Then decides to spend $10,000 marketing a new product line to all 10,000 of her business customers. At the end of the campaign, Miko’s company makes $10,000. Should Miko be happy or disappointed?
If we analyze these sales using an average, here’s what we find:
- Average Market Spend: $1/customer
- Average Customer Purchase: $1/customer
- Return for each dollar spent: $1 of marketing yields $1 in the purchased products
If we analyze these numbers assuming the 80/20 rule, we find something interesting:
- Average Market Spend: $1/customer
- Average Customer Purchases:
- Top 20% Customers - $8,000/2000 Customers = $4/customer
- Bottom 80% Customers - $2000/8000 customers = $0.25/customer
- Return for each marketing dollar spent,
- Top 20% customers - $1 of marketing yields $4.00/customer ($8,000/2000 customers)
- Bottom 80% Customer - $1 of marking yields $0.25 ($2000/8000 customers)
Put in this way, the 80/20 rule tells us that Miko made most of her money from the top 20% customers ($8000.00). If Miko had only marketed to her top 2000 customers she could have saved $8,000.00 in marketing costs. It’s true she would have lost $2000.00 in sales income, but is it really a good investment to spend $8000 to make $2000? Traditionally management only measures the average sale/customer/campaign. Averaging assumes that all customers buy equally and for the same reasons. Understanding 80/20 helps outlier leaders identify true opportunities.
Taking 80/20 one step further. What if Miko spent her entire marketing budget of $10,000 exclusively on the top 20% of her best customers? Using the 80/20 rule we can assume the same 4:1 ratio of purchases vs market spend. In which case, Miko would have made $40,000 from her $10,000 sales campaign investment. Meaning that for the same 10,000-dollar investment, Miko could choose either:
- Earning $10,000 using a traditional sales campaign.
- Earning $40,000 using a targeted 80/20 sales campaign.
Most business leaders prefer the extra $30,000 dollars. How about you?
I share this very “down & dirty” example to show the potential of an 80/20 analysis. In 1941 Joseph Juran was not looking at sales. The weak link for businesses back then was the manufacturing process. Back in 1941 the economic demand for products far exceeded total manufacturing productivity. Even the weakest salesperson can sell when demand is higher than production. Joseph Juran was helping manufactures supply that demand.
Today the situation is reversed. In today’s economy manufacturing far exceeds demand. A problem that requires solutions that are quite different from the pre & post world war II economies. Almost 80 years later, manufacturing is no longer the weakest link in business. Using the 80/20 rule savvy business leaders are fixing today's weakest link. While at the same time their competitors are still focused on solving modern business problems with 1941 economic solutions.
You may be asking, “What is the weakest link in business today?”
The weakest link in business today is the IT department. It turns out that 80% of root causes for mid-market business problems are in rooted in the traditional IT department business model.
Statistically, 50% of IT project deployments fail. When they succeed though, management should see a 4:1 improvement in employee productivity. Most management teams would be happy with a 2:1 improvement. Unfortunately, most successful technology deployments only provide a 1:1 improvement in overall employee productivity or risk mitigation. We saw this same 1:1 ratio in our Miko example. Is this a coincidence?
Whenever we see a 1:1 wash, after a technical change, we can be pretty confident that there is an 80/20 opportunity that has been ignored. For the CEO, this means that a business opportunity was missed. The trick is identifying the opportunity.
Joseph Juran helped turn around manufacturing using 80/20 analysis. Today with computers 80/20 analysis is much easier to do. It does require an understanding of the 100% of causes in order to weed out the 20%. Once that is narrowed down, it’s fairly simple to target just the 20%. By doing this, we have been able to help our clients increase overall worker productivity by 30% with a few small simple 80/20 tweaks.
The next step
For every business, the next step is a simple business review of the technology.
For the investor 80/20 is the key. In the Miko example, it was not just knowing that there is an opportunity. The trick is early identification of opportunities that nobody else can see.
That’s where 80/20 in IT Due Diligence analysis becomes so important. Unlike in 1941, maintaining a technical edge, in every department, is mission critical. Technical improvements should provide a targeted 4:1 improvement in worker productivity or in risk mitigation.
Outlier executives are successful because they look at technology in this way and are expecting a 4:1 improvement in business objectives with each technology change. At the same time, the Outlier Investor will review the technology with the same rigor as the seller’s business financials. Knowing that if the seller’s leadership team have the technology right, then they probably have the business piece right as well.
A good IT Due Diligence firm can easily recognize if the seller has been settling for 1:1 technical opportunities or aggressively focusing on 4:1 opportunities. In this way, the savvy outlier investor also uses 80/20. By looking at the 20% cause, meaning technology, the investor has a way to quickly filter out the bottom 80% without needing to review the financials. A good IT Due Diligence firm becomes the modern day investors secret weapon for success.
If you are an Investment Banker, check out our M&A IT Due Diligence Firm evaluation form. See if you are getting what you need during the IT Due Diligence phase of the business sale.
Also Check out our article, on the Top 5 M&A strategies investors used in 2018.