- November 13, 2016
- Posted by: David Marshall
- Category: Measurement, Productivity
If you’re familiar with the Pareto principle, and use it in some of your business decision making, maybe you should be familiar with the ABC Analysis.
The ABC Analysis is an offshoot of the Pareto principle, and is useful in identifying the successes in your business.
Let me explain.
The Pareto principle — also called the 80/20 rule — is the idea that 80% of your results come from 20% of your effort. That is, 80% of your revenue comes from 20% of your customers, and 80% of your product sales are of 20% of your items.
The ABC Analysis helps you identify those 20% of your items. Your A items are the top 10% of the units you sell, your B items are the second 10%, and the C items are the bottom 80%.
Jack Welch always used to say that business leaders should get rid of the bottom 10% of their staff every year. That is, cut the worst of your C players.
While I don’t know that I believe in what critics call the “rank and yank” — if I have a large pool of poor performers, what does that say about my hiring practices and professional development? — it’s a little more important to do this with your products and your customers.
Because while 80% of your reward comes from your 20% of your efforts, the converse is true: 20% of your reward comes from 80% of your efforts.
That means your C products only bring in 20% of your sales, and your C customers only deliver 20% of your profit, but they both take 80% of your time and energy. Think of the time you spend maintaining inventory, producing the product, maintaining the equipment, and so on for the very bottom 10% of your products. These costs eat into your profits on your products, and may not actually return anything.
And how much time do you spend invoicing your customers, maintaining their accounts, and having your salespeople maintain a relationship with them? Their higher costs result in lower gross margins for the few sales you do get, and they may even lose money in the long run.
Compare that to your better customers who do a lot of business with you, and have a higher gross margin. Compare the better products that you sell more of, and have a higher profit margin.
The better and larger customers have a tendency to participate in more of your product offerings, which is why the margins are higher. You get a more favorable mix of your products, whereas your worst customers only use you when they have to. They call you when you need a lower price, or when their regular supplier can’t deliver what they need.
(And if you felt bad for calling these people your “C” customers, just remember that you’re not their first choice in supplier either.)
There are a number of ways you can look at the results of your ABC analysis. You can adopt Jack Welch’s philosophy, and drop the bottom 10% of your customers and products, but eventually you’ll run out of C products, and you’ll have to start reclassifying parts of your B groups as C players. That’s when you start scraping bone to get the meat.
Your better questions are:
- How do I turn a C player into a B player?
- How do I get a C customer to buy from us more often?
- How do I get more people to buy this C product?
You need to consider whether you have the resources necessary to make that happen, and make it worthwhile.
Ultimately, look at the prices you’re charging or salary you’re paying, or training costs you’re investing. Should I increase my prices for this C product to make it worth having around? If you’re selling something and you’re not making money on it, get the price up or get the cost down. And if you can’t do that, get rid of it.
The same principle applies to your customers. Can I raise their prices to make them a more valuable customer? Can I get them to buy more often to raise their revenue? If you can’t do those things, then maybe you should just fire them as a customer.
In a company that’s always seeking improvement, and places to increase profits and reduce costs, run an ABC Analysis to make sure you can identify your best / worst— products and customer relationships, and then drop the bottom 10% that are actually eating into your overall profits.
I’ve been a manufacturing executive, as well as a sales and marketing professional, for a few decades. Now I help companies turn around their own business through an ABC analysis, management audit, and operational reviews. If you would like more information, please visit my website and connect with me on Twitter or LinkedIn.