Most people have heard of Pareto’s 80-20 principle on cause and effect, which theorizes that 20% of individual actions are often responsible for 80% of total results. This rule is useful in explaining outcomes in business relationships, economic events, and even social situations.

For example, government studies have shown that 80% of health care resources are consumed by 20% of the population. In assessing your own daily productivity, you might discover that 80% of your work is done in 20% of your workday. Psychologists studying the effectiveness of work groups have found that 80% of the work is done by 20% of a committee’s members. And so forth.

Many businesses have found the 80-20 principle to be especially relevant as it pertains to their customers. A long-held axiom is that 80% of sales come from the largest 20% of the customer base.

However, businesses should exercise caution before making the same assumption when examining customer profitability. It’s not that profits are spread more evenly among their customer base – in actuality, the highest profits are concentrated even more heavily in the top 20% of clients. In fact, the top 20% of clients may generate between 150% and 180% of a company’s profits. The next 60% of clients by volume are approximately breakeven, and the last 20% are unprofitable, actually losing about 50% to 80% of the organization’s profits, leaving the company with its 100% of total profits.

When the cumulative profitability of clients is graphed, the resulting plotted line resembles the head and torso of a whale, hence the name “whale curve.”

Example: In the whale curve above, the vertical axis represents the cumulative net operating profit, the horizontal axis shows 25 customers ranked by profitability, and the plotted line shows the cumulative profitability of these clients. In this case, the top 20% clients account for 165% of profits, the middle 60% earn a modest 15% of profits, and the bottom 20% lose 80% of the company’s net profits.

Interestingly, a company’s largest customers usually fall in one of the two extremes of profitability on the whale curve. Big clients are either very profitable or cost the business a lot of money. How can this be? Servicing large clients can often require special orders, deep discounts, and extraordinary demands on the company’s delivery system and personnel.

The realization that the biggest customer might be the least (or un-) profitable relationship should prompt a company to closely examine their processes and pricing. Carefully considering the effect of discounts and sales allowances is especially important with very large clients. Analyzing every level of large customers’ interaction with the company can uncover hidden costs that have dramatic effects at greater magnitudes. Finally, enacting activity-based pricing to better reflect the costs of serving large clients can bring larger relationships into line with the company’s revenue goals and allow a path to achieving higher profits with their existing client portfolio.

The Lake Ridge Bank Treasury Management team is here to help you maximize your business's potential. To start the conversation about how we can help, please reach out to me by email or phone (608.826.3516) today.

 

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