80/20 Pricing: Increasing Profits by Focusing

on High Impact Value Drivers

A lot means a little, and a little means a lot. In business, a few things are critically important,
while the majority are almost meaningless to success.

The Pareto Principle -- aka The 80/20 Rule or the Principle of Imbalance -- says that 80% of the
outputs in virtually any endeavour are generated by 20% of the inputs.

Vilfredo Pareto found that 80% of the land in Italy was owned by 20% of the population in
1906.

Volkswagen found that roughly 20% of the automobile build combinations were responsible for
80% of the profit margin.

Microsoft found that 20% of its software bugs caused 80% of the errors.

These 80/20 examples are ubiquitous in business. And the Principle extends farther. You can
80/20 the 20% as well, leading to 90/10 or even 99/1 splits.

Applying the 80/20 Rule to Business Pricing

Implementing 80/20 in your pricing strategy is one of the best kept secrets in business. The
challenge is that few organizations have figured out how to apply the Pareto Principle to pricing
in an effective manner.

There are three main reasons 80/20 is so hard to apply to pricing:

1. Businesses don’t like to turn away customers or product ideas. As a

result, most businesses are addicted to supporting many small
customers and products. This drains resources and resulting in non-
optimum use of assets and capital.
2. Businesses tend to treat all customers equally. “The market won’t
bear multiple price points for the same product.” This results in
earning margin from big customers, only to turn around and lose it
with small ones.
3. Pricing large numbers of SKUs optimally across a large customer base
is complex. Most businesses are not set up to analyze and optimize
 pricing based on value. This makes applying 80/20 to prices quite a
significant challenge.

ITW: A Case Study of Successful 80/20 Pricing

A groundbreaking example of successful 80/20 in action is Illinois Tool Works (ITW). ITW
developed its “80/20 Front to Back Process” starting in the 1980’s to drive revenue growth from
$300 million to over $18 billion. 80/20 has delivered world class operating margins, strong free
cash flow and high returns on capital investment for over 30 years.

ITW had a problem in 1980. Their costs kept going up, but they couldn’t recover the money in
higher prices. Competition and rising costs were driving margins down with no end in sight.

“When ITW began experimenting with 80/20, the company’s margins were increasingly being
challenged by a downturn in the automotive industry and competition from highly efficient
Japanese manufacturers.”

So what did ITW do? They launched a product-by-product profitability analysis.

Jim [Farrell] would say, ‘Give me all the part numbers in this segment of our business.’ And he’d
line them up and say, ‘Who’s the biggest, who’s the smallest,’ and he’d put the numbers into a
computer and, lo and behold, 20 percent of products gave you 80 percent of revenue and 20
percent of customers gave you 80 percent of your dollars. With one database of products after
another, they’d all be the same.”

Armed with this information, senior executives began to sell the 80/20 concept throughout
ITW’s business units. This innovative thinking began to percolate, but little actual change
ensued.

“People didn’t want to change it because they were all very focused on short-term incentive
plans. That meant that they weren’t going to adapt what we were trying to teach them. So we
changed the incentive plans.”

The result was an economic transformation across almost every business unit, unlocking
massive shareholder value. 80/20 allowed ITW to increase its profit margins, drive 19%
compound annual returns, and continue acquiring companies to reach over $18 billion in
revenue.

Source: https://www.itw.com/wpcontent/uploads/2012/12/043012_ITW100
Years_NookTablet.pdf

Step 1: Analyzing Revenue vs. Profitability

The first step is to analyze the revenue vs. profits across all of the customers. This table shows
an example of sorting customers into four quadrants by customer size.

Source: Getting Started with 80/20 (Strategex, Jul 10,

2018)https://strategex.com/getting-started-with-8020/

Here the top 50 customers (quadrant 1) generate 89% of revenues and 150% of total
profits. The bottom 50 customers (quadrant 4) generate only 1% of revenues and -40 of total
profits. A major difference!

At this stage you’ll likely start hearing objections as the data tells its story:

 “We can’t get rid of those little customers -- we’d be putting all our
eggs in one basket!”
 “Our big customers didn’t start out big. They started as small accounts
and we helped them grow.”

Step 2: Applying Quadrant Analysis to Drive 80/20 Pricing and Profitability

Now that you’ve got your customers broken down into quadrants, let’s take a look at each one
and what to do. This is the approach ITW has used in it’s “Playbook” (a mere three-page
document used widely across the organization).

Quadrant 1: The Fort

80/20 Strategy: Over-serve the 20% of companies generating 80% of revenues. Apply Key
Account Management and boost sales commissions to incentivize sales from this key segment.
This could allow you to reduce prices in Quad 1 to capture even more market share.

Quadrant 2: Necessary Evil

80/20 Strategy: Get customers to move from Quad 2 to Quad 1. Incentivize the sales team to
drive this transition with higher commissions. You can also incentivize Quad 2 customers with
better pricing on the ideal SKU mix to move up to Quad 1.

Quadrant 3: Transactional
80/20 Strategy: Move these customers away from direct outside sales to inside sales and
distributors. Establish a minimum order quantity and introduce quantity-based pricing to
incentivize larger purchases.

Quadrant 4: Eliminate / Isolate

80/20 Strategy: These low value, yet high effort customers add negative value to the business
by “pirating” resources and profits. Raise the prices substantially for these 80% of companies.
Because order quantity tends to be very small in this quadrant, even large price increases are
likely to go unnoticed. Customers won’t leave but margins will improve substantially.
Source: Finding Hidden Profit Through Quad Analysis (Strategex, Nov 1,
2015) https://strategex.com/finding-hidden-profit-through-quad-analysis/

Step 3: Realign Pricing by Quadrant to Increase EBITDA

The goal in step three is to develop a pricing structure where similar customers pay similar
prices for similar products. Normally the distribution of pricing in each quadrant is a mess. As a
result, margins are all over the place from customer to customer.

What you want is higher margins as you move from Quad 1 down to Quad 2, 3 and 4. As
customer size drops, orders get progressively smaller so margins per order should be higher.

The quadrant chart below shows what we typically find -- misaligned margins across the
quadrants.
Increasing value at this stage is driven by segmenting your customers by customer value (e.g.
size, growth, mix, etc.). Focusing on each segment, you then steps to raise and align profit
margins.

This process involves significant analysis and potentially customer interaction to identify
pockets of value. Asking these questions can help:

 Can customers buying outlier products absorb a price increase?

 What products -- even high priced ones -- are underpriced and should
priced higher?
 Where does the pricing power lie within each quadrant?
 How can we score each customer on pricing power?
 How can we transition pricing from referencing list price (invoice
price) to pocket price (cost to deliver)?

Results of Applying 80/20 Rule to Pricing

When we’ve applied 80/20 to optimizing our client’s pricing, we typically see a very substantial
EBITDA increase of 3-4%. Further a mere 1% increase in effective price across all customers can
result in between 10% and 25% EBITDA increase.

Using a version of this methodology ITW has achieved a 19% compound annual shareholder
return over 25 years. In addition, every acquisition ITW has made became profitable -- an
incredible 100% batting average.