Friday, March 2, 2007

The 2% Rule, or 98:2 Solution

You know the '80:20 Rule' - the Pareto Principle - that 80% of faults are caused by 20% of problems. Here's a similar rule: Items under 2% of budget get different rules.

Every organisation has it's "core business" and will/should actively monitor and control those inputs/supplies/services to remain profitable. They will be very sensitive to their major selection criteria on those.

But for the 'incidentals', different economics and criteria apply.

As a supplier or consumer, recognising which situation applies will help you greatly by being able to tailor your services to the consumers needs and maximise your profits.

If you're a builder and you can buy the same building products for 20% less with no other penalties, then there has to be a very strong reason to not change. Inertia isn't a strong business reason. "Family connections" probably are.

But what about those inputs/supplies/services that you don't use every day? The one and two percenters? The necessary 'noise'.

My plumbers charge $160/hour. If they need some printing done occasionally, how much time can be spent looking for 'the best deal'? The savings have to beat $160/hr spent. Taking a half-day to save 20% on a $1,000 printing job is a nett loss of $450!. (gain: $200, cost: 4*$160 = $640)

For the "1-2%" inputs, cost price is the least important determinant. Total Cost, including opportunity losses/forgone revenue etc, has to be used for a realistic economic comparison.

For the little things, the incidentals, most people put first one of:

  • quick or available
  • good or high-quality
  • close
  • reliable

For some people, it is always about the price. People on fixed-incomes are "time rich, money poor". They usually fall into this category. Others may be wealthy and always be "careful" or "tight" - there are no set rules for behaviour.

When the hotwater system has failed or the roof has flooded, you need someone Now! Someone who's going to do a Good Enough job, Real Soon. Even if they charge double you're probably happy to pay the money. The downside is not trading for one or more days - way more expensive.

If it's a service, like an accountant, that you are going to be using over an extended period and it's critical to your business, you may take some time over the decision and be very particular in your criteria and trade-offs. It's worth an hours' travel and 30% more to get the best advice and save a lot more!

The "2% Solution" has two business impacts:
  • In your marketing analysis, decide how much of your business is not decided on price alone - and build package of service and price accordingly.
  • Relationships are why do/don't return for repeat business. It's also why people ask for and give 'recomendations'.

The "2% Solution" can also inform what business segment you decide to be in.
If you are an Engineering and Construction firm and specialise in (steel) piplelines, you can choose to enter the "high volume/low margin" end of the business - supplying and laying the long straight bits, or enter the "low volume/high margin" end - building the complex valve/joiner units.

You can make good money at both ends.
Low Margins arise because of fierce competition - everyone can do the technical side.
High Margins are allowed when there is little competition - because the technicalities of the job are demanding/exacting.
Both ends need good management and tight fiscal control to remain profitable.

Technology has the horrible habit of quickly making the esoteric into the ordinary - being a technology leader as a point of differentiation means you can't stay still.

In 1991, it cost $10,000 for a CD-Writer and about as much for a disk that would store those 600Mb.
15 years later, writers were under $100 and disks over 20 times bigger for $150.

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