When shrinking down is the last option we have, how should we do it?

During times of crisis like the one inspired by the Covid-19 Pandemic, the economy is bound to feel a hit and the worst-case scenario is that we head into a recession. Many businesses have already felt the pain and are taking various measures to ensure that they stay afloat throughout this period. As we’ve all noticed, most businesses are opting to shrink down their resources; we’ve seen companies suddenly realizing that they have redundant positions and hence plan on laying off staff to ease their wage bill. Shrinking down has the domino effect of interfering with the company’s long-term goals and expansion/growth; it also means the arrival of the unfortunate event of lots of people losing their jobs but if it is the last option for a business, how exactly should they shrink down?

The principle of factor sparsity states that, for many events, roughly 80% of the effects come from 20% of the causes and it has never been more important than it is now. That means that, for a company, by identifying the 20% of events that lead to 80% of their outcome, they can be able to reduce the resources they spend by more than half while still maintaining their margins to within 20% of the value before the pandemic.

For many events, roughly 80% of the effects come from 20% of the causes — Vilfredo Pareto

Let us take a practical example with part of the research data we have at Insense Data Technologies. The business has 4,372 customers but half of their revenue only comes from 240 customers (5.49%). 80% of their revenue is generated by 1,170 customers (26.76%). What this means is that, this business can shift its focus, in each of their departments, to service only these 1,000 customers and they will still be able to maintain their margins at fairly within 20% of the original value, provided that their buying power remains the same and the business experiences no churn.

Pareto Analysis of the Customers

Take for instance the customer care department that is responsible for receiving calls and complaints from customers. According to the same principle of factor sparsity, 80% of complaints come from just 20% of the customers (most of which will fall within the last pareto quartile) and the business must thus be able to check if these 20% of the customers fall within the first Pareto quartile or not. Only the complaints from the first quartile pareto customers can be prioritized while all the rest can be ignored and the end result is that the business will be able to lower the complaints they are responding to by almost 80% and the human resources needed to do the same by roughly the same ratio. When it comes to treatment effects eg offering discounts to customers, sending out promotions or outreach messages, the business, instead of shrinking its budget, can instead focus the entire budget on their first quartile pareto customers and as our research data has shown, the returns are bound to more than double. The idea here is quite simple, if it costs you the same to treat a customer whose conversion would earn you $1,000 and a customer whose conversion would earn you $100, then it is 10 times more rewarding to treat the $1,000 spend customer.

Distribution of customers by Pareto Quartiles: The largest percentage of customers (4th quartile) is also the one from which the business earns the least and receives the highest number of complaints and customer care man-hours

An analysis of the products offered by the business proved a similar trend as the behavior of their customers proved. Of all the products the business sells, 80% of their revenue is earned from only 19.82% of their products with half the revenue being earned from only 5.84% of the products and 90% of the revenue being generated by only 31.62% of the products. The question therefore is, should the business continue spending huge resources on all their current product/service offering or should they focus only on the first quartile pareto products/services? It would appear to me that the first level decision point, all other factors held constant, would be to shrink their product offering to the first quartile pareto products and they will still be able to maintain their margins to within 20% off of the original value. By so doing, the business would also be able to cut down on all the expenses associated with maintaining and running the 80% of products/services that have been cut off.

Pareto Analysis of the company’s products offering: only 19.82 % of the products are responsible for a whooping 80% of the business revenue

When we talk about Pareto Principle and its effects on our decision making, we are not only talking about focus shift in products offering and customer management. Take for instance the marketing department that is probably utilizing numerous channels to pass their message to their audience. The team has resources working on various methods be it content marketing or running social media ads. At a time like this, the business must thus analyze their channels and understand which 20% of the channels are responsible for 80% of the conversions and then shift all their focus on the first quartile pareto channels. With this action, the business might be able to save 80% of their marketing expenses while not adversely affecting their customer acquisition.

Distribution of products by Pareto Quartiles: 83.8% of the products fall in the 4th quartile. Despite the high expenses the company incurs to maintain them, their overall contribution to the company’s revenue is almost negligible.

The first level of decision making is to adhere to the 80/20 rule: focus on the 20% that derive the most value and eventually maintain your margin shift to within only 20% so as to be able to weather this storm. We’re talking about the 20% of products/services, the 20% of customers, the 20% of marketing channels.

There are numerous examples I could give to drive the point home but the baseline remains the same. There may be tough times ahead and as we prepare for them, we need to make data-driven decisions now more than ever. The simplest of them is to adhere to the 80/20 rule: focus on the 20% that derive the most value and eventually maintain your margin shift to within only 20% so as to be able to weather this storm. Do not blindly lay off staff because you think they are redundant or based on their performance indicators. Instead, you might retain a poorly performing staff in a critical department but instead disband an entire department that’s offering a product that falls in the last pareto quartile. It is, however, important to note that this is slightly rudimentary because business decisions are made based on numerous other factors coming into play together but it is in deed a good starting point before adding on the other factors. The important thing to take home is that whatever decision you make at this point, does it minimize your expenses while maximizing your returns? Does it make Vilfredo Pareto happy for the tremendous effort he put to give us the 80/20 rule?

Founder, Techpreneur, Engineer and Data Scientist