The 80/20 Rule

Posted on July 17, 2020 by Lance Priemaza, One of Thousands of Business Coaches on Noomii.

There are a lot of rules in business. Hard rules, soft rules. The rule of 72. Never hold more than 10% REITs in an investment account. Never hire friends or family. Never say good enough. Revenue matching with expenses…
Today we’re going to talk about the 80/20 rule and luckily it’s not something that you need to live by, it’s something that is going to help you. It’s going to give you a better understanding of your business today, and we’ll be doing more posts in this little series about where it can take you. So sign up!
Basically it says that 80% of your profit will come from 20% of your products. Or in some cases products can be your services, clients, software, or whatever but you can see where this is going.
First let’s just clarify some things. Profit is different from revenue. Revenue is also referred to as sales, or income, or top line, but it’s the $20 that you receive for that widget that you just sold. Out of that $20 there are going to be input costs. It might cost you $5 in wood to make the widget. Then there’s your labour to make it, tools, rent, website costs, email hosting, etc. All of these things take that $20 down, and the amount you are left with is your profit, or net profit. Really quick recap without getting in depth; sales is the $20. When you minus the wood to make the widget, that’s your gross profit (in this case $15), then all your other expenses calculated as overhead gives you the net profit.
It’s important to understand this distinction because a lot of clients look at sales and not profit. Here’s a great example – milk is one of the most popular things bought at a supermarket. But, it is a loss leader. That means that not only does it not make money, but it loses money, and a lot to make it the best of the losers. The reason they always place milk at the back of the store is they hope by walking all the way through you will grab something else. So, milk brings you in the store and even though the store knows that it loses money they offer it in the hopes that you will buy something else that DOES make money. Complimentary products. Supermarkets sell A LOT of milk, but it is not making them their money.
We need to figure out line by line what every single product/service you offer makes in profit. I like to break this down to a single item sold so I can scale up the numbers later. Like figuring out what one cupcake in a bakery brings in profit. Profit per item. Once we have that we simply put in how much of that we sell and we have the net profit.
It can take a bit of work and setup to get this all done the first time and I would strongly suggest you take the time to set it up for future success so you don’t have to redo all the work every time you do this. And you should do it often! In a lot of my positions and businesses I calculated this every quarter. Again, a great setup at the start will save you a ton of time later. Use spreadsheets. Enter anything that’s a variable into separate cells so you can adjust later.
Now that we have all of our net profit info we need a percentage. So what do we use, what’s the formula? Luckily we’ve done all the really hard work, we simply divide the profit from that item by the net profit for the whole company which we’ll have in our financials from our accountant, or accounting system if you keep it up to date.
Here’s an example from a business that I actually owned (products and numbers fabricated but loosely accurate):

We can see from this example that we kill it with the cakes! Those two items make up 73% of our profit. We also see that cheesecakes are losing money. Why? Do we have them priced wrong? Do people not like them? Well, we can see from this example that the cost to make them is just way too high. It’s not always this obvious, but it sometimes is. This is where I have gone in and helped a lot of companies very quickly, because the numbers don’t lie. Maybe the owner really likes cheesecake and refuses to compromise on ingredients. Great. Make them at home and don’t sell them because they are your loss leader. Now there are reasons to sell them just like milk, but that’s where asking a lot of questions and working with a coach can help clear a lot of things up. Is there really a reason to sell them or do we cut them? Jack Welch is famous for going into General Electric and cutting like a madman until they were a profitable company.
Let’s apply this to our lives for a moment. Let’s say you are working two jobs, or three just to try and make a paycheck. Maybe you picked up a part time job to save for a vacation or special purchase. If you sit down and figure out how much income you are making from each source you may be very surprised at the result. A friend of mine for example really wanted to be a social media influencer. They spent all their time focusing on that and did little else. It takes a long time to get any traction, and then even more time to make money at it. They were so excited when they started seeing their first bits of money come in! Validation! But it wasn’t paying the bills so they got a job. Working part time they made enough to pay their bills, buy new equipment for vlogging, take some trips to try and show their audience, and even have some spending money left over. At this point I had to ask, “Why not just focus on this part time job? It’s far more lucrative.” We ran the numbers and restructured their week so that they were working full time on the second job that was going really well and making great money and working part time on the social media side. They loved the social media, we didn’t want to cut it out. It made a little money too. But, a little change went a very long way in helping their stress, save for some goals, and improve their quality of life.
Surprisingly the 80/20 rule is very accurate. I’ve worked across many different industries and it can always give very good insight. Keep in mind that it will also evolve as you go, that’s why we need to keep analyzing it. If we cut out the cheesecakes where does that time go? How does that change our profit? Your business is constantly evolving. You need to keep ahead of it.
Join us next time for how the 80/20 rule can help you define your competitive advantage.