Follow the 120/20 Rule

It’s time to ditch the 80/20 rule and focus, instead, on the 120/20 rule. We can all be much more profitable for the exercise.

As we’ve heard from every management guru in the universe, the 80/20 rule expresses the idea that 20% of a company’s customers will produce 80% of profits. It’s a generic reminder that a small portion of any endeavor generates a disproportionately large share of impact, which makes it a shorthand description of life, both inside the company and at home.

It’s great, as far as it goes, but it doesn’t go nearly far enough. The challenge of the 80/20 rule is its unspoken assumption that all our sales are profitable. One group of customers produces 80% of profits and another group generates the other 20% of profits, so it all adds up to 100%. Except, for many companies, that’s not exactly how it works.

Instead, 120/20 can be the more relevant rule. One group of customers is generating approximately 120% of earnings, which would be impossible if there weren’t another cohort being serviced at a substantial loss.

Unprofitable clients can pop up in a number of locations, from the one-off projects that take up much more time than budgeted to the clients that demand extra services without covering their added costs. Unprofitable customers can appear in a legacy business that is always assumed—but never proven—to make a full contribution to overhead, or in the special inventory or equipment purchased to service a client with neither the margins nor the volume to justify the investment.

At times, these unprofitable clients will be high-volume accounts with dangerously low margins. Often, though, they are smaller customers that simply fail to earn their place in our family. Some are longstanding accounts that have never been re-assessed in light of current cost structures. Others were added when business was slow and we were happy to take anyone who “makes a contribution to overhead.” (See: The Most Damaging Lie in Business.) No matter how they arrived, though, they are costing us time and money today.

By identifying and addressing these clients, we might find we can increase profitability dramatically without making any new investments in staff, equipment, inventory or working capital. In fact, we might be able to pull extra cash out of the business, or apply it much more productively, if we tackle the problems posed by unprofitable patrons.

We can figure out the specifics, as they apply to our businesses, by asking the accounting department to identify which customers are generating losses and how those losses are produced. Armed with that insight, we can take any number of steps to reduce their impact, including:

1. Revise pricing to reflect the full cost of service.
2. Seek cost-sharing for special equipment or inventory.
3. Spin off an unprofitable legacy business to its managers.
4. Cut the losers lose.

Equally important, we can use the insights gained from this analysis to refocus our sales and marketing efforts, reducing the likelihood that we will continue to spend money and pay commissions (See: Stupid Sales.) to win more of these accounts.

We must exercise some care when we apply the 120/20 rule, as some clients might add value that doesn’t appear in the financial statements. This could be the case, for example, with a client that brings in other, more profitable business, or one that bolsters our offerings to other customers in some way. These exceptions are rare, but should always be considered.

In most cases, though, focusing on the 120/20 rule will enable us to increase profitability substantially, while also reducing overall costs, capital and risk.