You’ve probably heard about the 80/20 rule, known also as Pareto Principle or the Law of the Vital Few.
In business, pay closer attention to what those vital few can be telling you about the risks ahead.
The Vital Few in business
It is not uncommon to observe something like this in business: 80% of profits from 20% of customers; 80% of sales from 20% of products; 80% of sales made by 20% of the sales staff; 80% of complaints from 20% of customers, etc.
There is nothing special about the ‘80%’. But the key is that your business could be generating the bulk of its revenue from a few ‘star performers’ (be they customers, products, staff, etc).
The common approach of concentrating more on these top performers has its obvious merits. It also helps identify some of the “lower-yielding” customers (for instance) who seem to demand the greatest amount of energy from your business for the lowest return.
Risk ahead
However, discovering the 80/20 in your business may also highlight some underlying risks. For instance, what do your top customers have in common? Are they in the same industry? Are they in related industries? Are they exposed to similar risks?
This is concentration risk: a higher risk to your business from having your client base (or your products) concentrated in the hands of the few. If those few experience business difficulties so will your business.
Example
If you own a large catering services company with offices across the country, you may discover that the bulk of your revenue comes from a handful of, say, legal firms. And if you dig a bit deeper you may discover that most of these legal firms are in Canberra (Australia). A little more investigation and you find that most of these rely on the outsourcing of legal work by government departments.
This means that your entire business can be in jeopardy if, say, the government decided to cut back on legal outsourcing (e.g., close to election, new government, etc).
One ministerial decision and your ‘national’ business will go from boom to bust.
What about the recent events in the live cattle exports to Indonesia?
What can be done?
The reason why you have such customer aggregation may not be just coincidence. Understanding why can require focused and creative detective work, but the exercise may help you discover a common underlying source of risk. Then ask yourself am I prepared to take such a risk?
Also, try to understand why the majority of your customers are generating the smallest part of your revenue. There can be a wealth of information there that you can use to reduce your reliance on the “few”[This will be the subject for a future post.]
It can be exciting to discover the “critical few” in your business, but remember that the rewards they generate may carry concentration risk. Is your business earning enough to be well compensated for this risk? How can you boost the revenues from the other 80% to mitigate this risk?