80/20 Pricing: Increasing Profits by Focusing on High Impact Value Drivers

Paul Hunt
Paul Hunt
Nov 1 · 7 min read

A lot means a little, and a little means a lot. In business, a few things are critically important, while the majority are almost meaningless to success.

The Pareto Principle — aka The 80/20 Rule or the Principle of Imbalance — says that 80% of the outputs in virtually any endeavor are generated by 20% of the inputs.

Vilfredo Pareto found that 80% of the land in Italy was owned by 20% of the population in 1906.

Volkswagen found that roughly 20% of the automobile build combinations were responsible for 80% of the profit margin.

Microsoft found that 20% of its software bugs caused 80% of the errors.

These 80/20 examples are ubiquitous in business. And the Principle extends farther. You can 80/20 the 20% as well, leading to 90/10 or even 99/1 splits.

Implementing 80/20 in your pricing strategy is one of the best-kept secrets in business. The challenge is that few organizations have figured out how to apply the Pareto Principle to pricing in an effective manner.

There are three main reasons 80/20 is so hard to apply to pricing:

  1. Businesses don’t like to turn away customers or product ideas. As a result, most businesses are addicted to supporting many small customers and products. This drains resources resulting in non-optimum use of assets and capital.
  2. Businesses tend to treat all customers equally. “The market won’t bear multiple price points for the same product.” This results in earning margin from big customers, only to turn around and lose it with small ones.
  3. Pricing large numbers of SKUs optimally across a large customer base is complex. Most businesses are not set up to analyze and optimize pricing based on value. This makes applying 80/20 to prices quite a significant challenge.

A groundbreaking example of successful 80/20 in action is Illinois Tool Works (ITW). ITW developed its “80/20 Front to Back Process” starting in the 1980’s to drive revenue growth from $300 million to over $18 billion. 80/20 has delivered world class operating margins, strong free cash flow and high returns on capital investment for over 30 years.

ITW had a problem in 1980. Their costs kept going up, but they couldn’t recover the money in higher prices. Competition and rising costs were driving margins down with no end in sight.

“When ITW began experimenting with 80/20, the company’s margins were increasingly being challenged by a downturn in the automotive industry and competition from highly efficient Japanese manufacturers.”

So what did ITW do? They launched a product-by-product profitability analysis.

Jim [Farrell] would say, ‘Give me all the part numbers in this segment of our business.’ And he’d line them up and say, ‘Who’s the biggest, who’s the smallest,’ and he’d put the numbers into a computer and, lo and behold, 20 percent of products gave you 80 percent of revenue and 20 percent of customers gave you 80 percent of your dollars. With one database of products after another, they’d all be the same.”

Armed with this information, senior executives began to sell the 80/20 concept throughout ITW’s business units. This innovative thinking began to percolate, but little actual change ensued.

“People didn’t want to change it because they were all very focused on short-term incentive plans. That meant that they weren’t going to adopt what we were trying to teach them. So we changed the incentive plans.”

The result was an economic transformation across almost every business unit, unlocking massive shareholder value. 80/20 allowed ITW to increase its profit margins, drive 19% compound annual returns, and continue acquiring companies to reach over $18 billion in revenue.

Source: https://www.itw.com/wpcontent/uploads/2012/12/043012_ITW100Years_NookTablet.pdf

The first step is to analyze the revenue vs. profits across all of the customers. This table shows an example of sorting customers into four quadrants by customer size.

Source: Getting Started with 80/20 (Strategex, Jul 10, 2018) https://strategex.com/getting-started-with-8020/

Here the top 50 customers (quadrant 1) generate 89% of revenues and 150% of total profits. The bottom 50 customers (quadrant 4) generate only 1% of revenues and -40 of total profits. A major difference!

At this stage you’ll likely start hearing objections as the data tells its story:

  • “We can’t get rid of those little customers — we’d be putting all our eggs in one basket!”
  • “Our big customers didn’t start out big. They started as small accounts and we helped them grow.”

Now that you’ve got your customers broken down into quadrants, let’s take a look at each one and what to do. This is the approach ITW has used in it’s “Playbook” (a mere three-page document used widely across the organization).

Quadrant 1: The Fort

80/20 Strategy: Over-serve the 20% of companies generating 80% of revenues. Apply Key Account Management and boost sales commissions to incentivize sales from this key segment. This could allow you to reduce prices in Quad 1 to capture even more market share.

Quadrant 2: Necessary Evil

80/20 Strategy: Get customers to move from Quad 2 to Quad 1. Incentivize the sales team to drive this transition with higher commissions. You can also incentivize Quad 2 customers with better pricing on the ideal SKU mix to move up to Quad 1.

Quadrant 3: Transactional

80/20 Strategy: Move these customers away from direct outside sales to inside sales and distributors. Establish a minimum order quantity and introduce quantity-based pricing to incentivize larger purchases.

Quadrant 4: Eliminate / Isolate

80/20 Strategy: These low value, yet high effort customers add negative value to the business by “pirating” resources and profits. Raise the prices in this quad substantially for this. Because order quantity tends to be very small in this quadrant, even large price increases are likely to go unnoticed. Customers usually don’t leave but margins will improve substantially.

Source: Finding Hidden Profit Through Quad Analysis (Strategex, Nov 1, 2015) https://strategex.com/finding-hidden-profit-through-quad-analysis/

The goal in step three is to develop a pricing structure where similar customers pay similar prices for similar products. Normally the distribution of pricing in each quadrant is a mess. As a result, margins are all over the place from customer to customer.

What you want is higher margins as you move from Quad 1 down to Quad 2, 3 and 4. As customer size drops, orders get progressively smaller so margins per order should be higher.

The quadrant chart below shows what we typically find — misaligned margins across the quadrants.

Increasing value at this stage is driven by segmenting your customers by customer value (e.g. size, growth, mix, etc.). Focusing on each segment, you then take steps to raise and align profit margins.

This process involves significant analysis and potentially customer interaction to identify pockets of value. Asking these questions can help:

  • Can customers buy outlier products absorb a price increase?
  • What products — even high priced ones — are underpriced and should be priced higher?
  • Where does the pricing power lie within each quadrant?
  • How can we score each customer on pricing power?

When we’ve applied 80/20 to optimizing our client’s pricing, we typically see a very substantial EBITDA increase of 3–4%. Further, a mere 1% increase in effective price across all customers can result in between 10% and 25% EBITDA increase.

Using a version of this methodology ITW has achieved a 19% compound annual shareholder return over 25 years. In addition, every acquisition ITW has made became profitable — an incredible 100% batting average.

Data Driven Investor

from confusion to clarity, not insanity

Paul Hunt

Written by

Paul Hunt

As President of Pricing Solutions, I have specialized in pricing for over 20 years over 1,000+ client engagements in a wide range of industries.

Data Driven Investor

from confusion to clarity, not insanity

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