The Pareto Principle (80/20 rule) has been widely cited in university courses, whitepapers, and research studies as a fundamental law of business profitability (Koch, 2011). It suggests that 80% of a company's profits come from just 20% of its customers, products, or sales channels. While this heuristic is helpful for strategic focus, it does not always hold true across different industries and market conditions.
Analyzing the Profit Curve: Does it Follow the 80/20 Rule?
The provided profit curve, shown in the image, serves as a clear empirical test against the strict application of the Pareto Principle. Instead of a steep initial accumulation of profit followed by a long plateau, the curve demonstrates a parabolic or bell-shaped distribution. This means that profitability is more evenly spread across customers than concentrated in a small elite group.
Key Data Points from the Graph:
- Total Customers Analyzed: 1,676
- Profitable Customers: 51.07%
- Unprofitable Customers: 48.92%
- Potential Profit: $1,401,480
- Actual Realized Profit: $396,199
Contrary to the expected Pareto concentration, this distribution significantly contradicts the 80/20 rule. Instead of a steep initial accumulation, a peak, and then a decline, we see a more gradual accumulation, challenging the notion that profitability is dominated by a select few.
The graph in question, which represents the profitability distribution of all customers, does not follow a strict 80/20 distribution. Compared to the empirical analysis of profitability in various industries, this dataset shows a more symmetrical spread rather than the sharp initial accumulation predicted by Pareto. This suggests that factors beyond simple concentration influence profitability, aligning with findings from diverse sectors like retail and subscription-based businesses. Instead, it exhibits a parabolic or bell-shaped curve, indicating a broader spread of profitability rather than a sharp concentration among a small segment of customers.
Key Observations from the Graph:
- Symmetrical Shape: Unlike an 80/20 distribution where profits accumulate rapidly at the beginning and then plateau, this curve shows gradual accumulation and then a decline.
- Customer Profitability Split: More than 50% of customers are profitable, while nearly 49% contribute to losses or negligible gains.
- Divergence from Pareto: If the Pareto Principle is applied strictly, we would expect only 20% of customers to generate most of the profit, which is not the case here.
This suggests that profitability is more evenly spread across a wider range of customers in this specific dataset than concentrated in a small elite group.
Why Doesn't the 80/20 Rule Always Apply?
The 80/20 rule is not a universal law but rather a general observation. Many industries and businesses experience different profitability distributions due to factors such as:
1. High Fixed Cost Businesses
- Industries like manufacturing, logistics, and telecommunications have high fixed costs, meaning that profitability depends more on scale and efficiency than just a tiny group of high-value customers.
2. Subscription & Recurring Revenue Models
- SaaS companies, streaming services, and insurance providers often rely on a large volume of moderately profitable customers rather than a small elite group.
3. Retail & E-commerce Diversification
- In retail and e-commerce, profitability is often spread across various customer segments and purchase behaviors, making the 80/20 rule less applicable.
4. Market Dynamics & Competition
- Companies must cater to a broader range of customers in highly competitive markets rather than relying on a small subset.
Steps to Analyze Profitability Curves and Avoid Business Risks
To ensure a company doesn't fall into the trap of assuming an 80/20 distribution, it's essential to conduct proper profitability analytics. Here are key steps to follow:
1. Conduct an ABC Customer Analysis
- Segment customers into A (most profitable), B (moderately profitable), and C (least profitable) to see if there is an actual Pareto-like distribution.
2. Build a Cumulative Profit Curve
- Sort customers by profitability and plot a cumulative profit curve to identify where most profits come from.
3. Compare with Other Cost Structures
- Factor in cost-to-serve metrics to avoid overestimating specific customer segments' fundamental contribution to profit.
4. Use Activity-Based Costing (ABC Costing)
- Implement ABC costing to allocate costs to different customer segments and channels properly, ensuring a realistic view of profitability.
5. Avoid Over-Reliance on a Single Framework
- Instead of blindly applying Pareto's 80/20 rule, use empirical data and adjust strategies based on actual profitability patterns. Implementing modern analytics, such as activity-based costing (ABC), customer lifetime value (CLV) analysis, and predictive modeling, can help refine decision-making. Tracking key profitability metrics over time enables companies to proactively identify trends and adjust strategies.
Conclusion: The Importance of Data-Driven Profitability Analysis
The 80/20 rule is a useful business guideline, but it should not be considered an unchangeable principle. Evidence from profit curve analysis clearly indicates that profitability patterns can vary widely based on industry, customer base, and business model. Companies should employ modern analytics, Activity-Based Costing (ABC), and customer segmentation techniques to gain a deeper understanding of their profitability distribution, rather than assuming a consistent Pareto-like pattern.
Moreover, profitability may be more evenly distributed than the 80/20 rule suggests. To make informed decisions, companies need to rely on accurate data instead of assuming that a small percentage of customers or products will always generate the majority of profits. This cautious approach is essential to avoid missed opportunities and to ensure a comprehensive understanding of the business's profitability.
By adopting a data-driven approach, businesses can optimize their customer base, refine pricing strategies, and allocate resources efficiently, leading to sustainable profitability without unnecessary risks. This approach provides a solid foundation for decision-making, giving you the confidence that your strategies are based on accurate and reliable data.
💡 Want to know if your business follows the 80/20 rule? Start by analyzing your profit distribution and avoid assumptions that could lead to missed opportunities!
References
- Anderson, C. (2006). The Long Tail: Why the Future of Business is Selling Less of More. Hyperion.
- Kaplan, R. S., & Anderson, S. R. (2013). Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits. Harvard Business Press.
- Koch, R. (2011). The 80/20 Principle: The Secret to Achieving More with Less. Crown Business.
- Tzuo, T., & Weisert, G. (2018). Subscribed: Why the Subscription Model Will Be Your Company's Future - and What to Do About It. Portfolio.
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Pedro San Martin, CPA, MBA
Principal EPM, Asher / PwC Interaméricas
Can be contacted at
psanmartin@...------------------------------