80/20 Accounting

The 80/20 rule (Pareto Principle) is one of the most useful we will ever encounter. Let’s discuss its use with 80/20 accounting. This is about focusing on the 20% of customers, products, expenses, etc. that account for most of our company’s results.

A Prior Example

In the posting 80/20 Rule for Receivables Management I gave an example of how the 80/20 rule can be used to simplify the collection process. Essentially the idea is that in accordance with the 80/20 rule approximately 80% of past due amounts will be the result of 20% of customers. Furthermore, that same 20% of customers will also likely be the reason for approximately 80% of the customer complaints, returns, and other problems you have with customers. In fact, it may be that these customers are ones that you may not want to focus on when trying to increase sales and perhaps even stop selling to. Of course, you will need to weigh all the factors, but just remember that it is possible to have a customer who is does not represent a good use of you time when it comes to selling more.

Other Areas 80/20 Accounting Applies

Another classic example of using 80/20 accounting involves inventory management. One of the biggest drains on cash is carrying excess inventory. See 3 Low Cost Sources of Cash – Part 1 and Small Inventory – Big Benefits for more on this. Basically the idea is much like receivables in that approximately 80% of your inventory value is likely to come from around 20% of you items and approximately 80% of sales is likely to come from around 20% of your items. So, if you want to control the amount of money tied up in inventory focus on that 20% and see if you can reduce the amount you are carrying. To do this you’ll need to consider demand, the time to reorder, and the consequences of being out of stock. This will be helps you determine the appropriate stocking levels, including sufficient safety stock.

In line with the above statement that approximately 80% of sales is likely to come from around 20% of your items you can begin to identify the items that are not making any meaningful contribution and begin to experiment with either eliminating them entirely or replacing them with another product. It should be a regular practice to review what is selling and what is not so that you have the appropriate mix of products.

Another way to use 80/20 accounting involves expense management. Do some analysis of your expenses and you will likely find that approximately 20% of your expense lines make up around 80% of your total expenses This is of course somewhat dependent on the kind of business but does provide a way to see where your money is really going and offers the opportunity to perhaps reduce some of these expenses. Here is a good time to take a deeper dive. Let’s say you have 20 expense line items and that 20% of those (4 items) makes up about 70% of your expenses. Let’s also assume that those 4 line items are not ones that you can really do anything to reduce. That means you may want to only consider the remaining 16 line items and do the same 80/20 analysis of them. You may well find that two or three of those 16 items comprise about 80% of the total of those 16 items. Again, this gives you a way to focus on the items you may be able to reduce. One more thing to consider here is the detail for a particular line item. It may be that a particular item or two has significant impact on the total of an expense line. It can be helpful to dig into those items and do an 80/20 analysis of the details in these accounts. It may be that well over 50% of a particular expense is caused by only one or two items within it and that they can be reduced or even eliminated.

Obviously there are many other areas where this concept works, but one in particular deserves mentioning. That is human resources. Examine your staffing costs and carefully evaluate the cost and contribution of each position and individual. You may find that some roles can be combined and headcount reduced or that some roles are redundant or even unneeded.

Are you making judicious use of the 80/20 rule in the accounting area? It is one of the most powerful tools at your disposal.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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