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Recent research has shown that once the full cost of supporting customers is taken into account, the majority of customers (usually around 80%) are not profitable at all. In fact studies carried out by Professors Cooper and Kaplan at the Harvard Business School have led them to the so called "20 - 225 rule". It applies equally to both private sector and public sector organisations.
The Rule states that typically 20% of the customers account for 225% of the profits (or value added), which of course means that the other 80% "lose" 125 percent of the profits (or value added).
It also says that typically 20% of the products (or services) account for 225% of the profits (or value added), which of course means that the other 80% "lose" 125 percent of the profits (or value added).
This is dangerous, not only because we end up supporting many customers and products which lose us money, but equally dangerously, we don't support as well as we should, the 20% that REALLY matter.
When I work with people on this issue they find it tempting to jump to the conclusion that we should therefore ditch the 80% which cost us money. This would be a mistake. The aim should be to make the unprofitable customers and products profitable by changing the way we deliver the product/service or by changing the overall package or by re-pricing. Only as a final resort, would we want to exit from the business but this is sometimes the only option.
Increasingly, organisations are going to menu-based pricing where costs to the customer is determined not only by the volume and mix of product purchased but also by the method of delivering to and servicing the customer.
The other conclusion that's tempting to jump to, is that the worst 80% of customers are the small ones. In actual fact, sometimes the larger customers are the worst ones. Again, the solution is not about getting rid of them, it's about changing the way we service them or charge them.
You may be thinking that this is a different subject for Bruce to be talking about. Well, in a way it is because the great majority of my work is in 'softer' issues such as strategy, culture and how people can achieve far more than anyone thought possible. But in another way it isn't because one of my competitive differences has been my combination of hard training and soft expertise.
Enough of the advertising, although I didn't realise it at the time, I learnt the lessons of the 20:225 Rule the hard way. When I was much younger and knew even less than I know now, I was the senior financial person at Dulux Paints. Our costing system was very successful at accounting down to the level of raw materials and container costs (which were the majority of the costs), however we made no attempt to apportion the manufacturing,
testing and selling costs to products. As you probably know, some paints are far more difficult and expensive to make, test and sell than others. This is mainly because some are made in big batches and others in far smaller batches and partly because some need to tested for far longer than others.
Anyway, as a result of our costing system, we under-costed the difficult paints such as metallic car paints and over-costed the easy paints such as white latex. And because our pricing was based the costing system we developed an enormously high share of the Automotive Market and suffered in Trade Painter Market. This probably put Resene Paints on the map.
Recently I've been involved in helping two organisations analyse their customers in terms of the 20-225 Rule and sorted out the 20% which are strategic, significant for the future and profitable.
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Helps large organisations be focussed, fast and flexible. Places where people have more meaning, depth and connection.
Expert in Strategy, Structure, Culture and Leadership Development.
One of NZ's most experienced change agents.