Using the 80/20 Rule for Business Finance Success
The Pareto principle, also known as the 80/20 rule, states that 80% of your outcomes (or outputs) stem from just 20% of your inputs (or causes).
When applied to business, this distribution principle can be seen in just about every department or area:
- Sales: 80% of a sales come from 20% of clients.
- Customer service: 80% of complaints or returns relate to 20% of products or issues.
- Distribution and logistics: 80% of shipping costs are associated with 20% of destinations or routes.
- Inventory: 80% of stock costs come from 20% of the items.
- Supplier management: 80% of supplies are sourced from 20% of suppliers.
Business owners and leaders are busy; they can't be across every single department or metric. Staying focused on your high-level goals instead of getting bogged down in the weeds is crucial.
The challenge, then, is knowing which areas to concentrate on for maximum impact.
How to Use the 80/20 Rule for Business Finance Success
Where to Focus 20% of Efforts
1. The Key Department: Sales
Sales, unsurprisingly, kickstart our journey through the 80/20 of business finance. Beyond its obvious role, it embodies the pulse of a business's health. A growth rate between 10% to 20% annually is the sweet spot for most. Going below 10% may signify stagnation, while above 20% can strain resources and capital.
Key takeaway: Aim for a yearly growth rate between 10% and 20% for a balanced and sustainable growth trajectory.
2. The Key Metric: Gross Profit
Gross profit, calculated by subtracting direct costs from your sales revenue, should be the star player in your financial playbook. This number fuses sales revenue with operational costs, presenting an accurate picture of your business’s financial efficiency.
In the vast expanse of industries, the 80/20 benchmark for gross profit hovers around 40%. While this might seem generic, it serves as a guiding figure for most enterprises. And it's not just about gross profit in terms of dollars; the quality or percentage of gross profit should be under constant scrutiny.
Key takeaway: Aim for a gross profit percentage around 40%. Regularly review the factors impacting it, such as what and how you sell, to whom, delivery efficacy, and cost of inputs.
3. The Key Catalyst: Working Capital
Here, the balance sheet enters the stage. Working capital — comprising debtors (accounts receivable), stock (or work in progress), and creditors (accounts payable)—is pivotal in assessing liquidity and operational efficiency.
It's not just about having cash in the bank. It's about effectively managing these three elements to ensure optimal cash flow. Respectful relationships with creditors, efficient stock management (neither too much nor too little), and expedited receivables can make or break your cash flow.
Key takeaway: Strive to reduce working capital relative to business growth. Efficiently managing debtors, stock, and creditors can lead to a stronger cash position.
Bringing it All Together
Growth in revenue and maintaining or enhancing gross profit percentage naturally boosts gross profit dollars. More of these dollars, under the 80/20 principle, augments business profitability. But, profitability alone isn't the endgame. The ultimate goal is generating substantial cash flow. This is where working capital dances in, bridging profitability with cash generation.
To be in the elite circle, aim for a 15% positive gap between your gross profit percentage and your working capital percentage. Anything between 10% to 15% is commendable, while figures below 5% demand attention.
Conclusion
The 80/20 principle of business finance demystifies the choreography of numbers every business owner or leader grapples with. By focusing on sales growth, honing in on gross profit, and adeptly managing working capital, you can fortify both profitability and cash flow. This clarity paves the way for informed decision-making, allowing you to remain centered on their overarching business vision.
Become a better business owner
Join 350+ business owners and key decision-makers who receive practical business and accounting tips every week for free. Sign up now.
