The 80/20 principle | Richard Koch

Published: 1999

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This is the classic book written by the management consultant Richard Koch in 1997. The book builds on the principle outlined by the Italian Vilfredo Pareto as early as 1897. In short, the 80/20 principle deal with the fact that a minority of causes, inputs or investments usually lead to the majority of the results, outputs or rewards. For example, 80% of what you achieve at your job comes from 20% of the time spent. The imbalance can be 65/35, 70/30, 75/25, 80/20, 95/5 or 99/1 or any numbers in between. The numbers also do not have to reach 100.

SIMILARITIES WITH THE CHAOS THEORY. Amongst similarities between the chaos theory and the 80/20 principle are the concepts of imbalance, non-linearity, the idea that feedback loops distort and disturb the balance and the idea of the critical point. Reality consists of a number of influencing factors, where cause and effect are difficult to distinguish.

80% OF THE VALUE OF A BOOK ON 20% OF THE PAGES. The 80/20 principle claims that there is a built-in imbalance between cause and effect, input and output as well as effort and reward. Inputs are usually placed in two categories: (1) the minority that has a small significance and (2) a small minority that has a large, decisive significance. For example, 80% of a book’s value may be on 20% or less of its pages.

80/20 IN MOST BUSINESSES. The author mentions a case in the management consulting business where it was found that 80% of the profits came from 20% of the customers (large and long-term, as you can use younger and cheaper labor). They also found that 80% of the results available to customers were the result of concentrating on 20% of the most important issues. If a company realizes that 80% of their profits come from 20% of their activities, it should place the greatest emphasis on selling more of these products. Even in the case of individual employees, it is likely that 80% of the value is generated within a small part of their working time.

HOW TO THINK ABOUT STRATEGY. Thinking about competitors leads you directly into the understanding of what is key in the business. Ask yourself two questions: (1) are you facing a different main competitor in this part of the business compared to the rest of it and (2) do you and your competitor have the same sales or market share in the two areas or are they relatively stronger in one area and you relatively stronger on another? Understand also how shortcomings negatively affect your most strategic consumers. Like many other quality issues, Pareto’s law applies: if you fix the most important 20% of your quality deficiencies, you will bring in 80% of the improvements. Offer fewer options, less frills, less service and much lower price.

FOCUS ON THE MOST IMPORTANT 20%. Since writing the book in 1997, Richard Koch has had a great track-record as an investor. In his book, he writes that 80% of the increase in assets in most long-term portfolios comes from less than 20% of investments. It is important to carefully select these investments – and then monitor them as a hawk.

KEEP IT SIMPLE. Simple and “pure” market shares are very valuable. The returns from simple economies of scale can been obscured by the cost of complexity, which is associated with complicated economies of scale. And different parts of the business usually have different competitors and different relative strengths in relation to these competitors. When a business is dominant in its narrowly limited niche, it is likely that the return is many times greater than in the niches where one is fighting against a dominant competitor.

FIRST MOVER ADVANTAGE. A company that in the early stages offers a product that is 10% better than its competitors can eventually achieve a relative market share of 100 or even 200%, even if the competitors later come up with a better product. Larger profits result in one or more of the following: (1) larger reinvestments in products and services, (2) investment in an increasing market share through sales and marketing efforts and / or acquisitions, (3) higher returns to employees, which attracts and retains skills , (4) greater return to shareholders, which can reduce the cost of capital, which facilitates investment and / or acquisitions. Over time, 80% of the market is usually supplied by 20% or fewer of the suppliers who generally also become the most profitable.

MOVIE BUSINESS – WINNER TAKES MOST. One of the most dramatic examples of the 80/20 principle concerns movies. The author mentions a study of the revenue and lifespan of 300 films released over an 18-month period. They found that four films – only 1.3% of the total – pulled in 80% of the ticket revenue; the other 296 films (or 98.7%) pulled in 20% of the total revenue. Movies, which are a good example of a free market, practically produce a 80/1 rule, a very clear demonstration of the principle of imbalance.

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