Practical Thoughts on Forecasting, Planning and Budgeting
Copyright Alistair Davidson, 2009. All rights reserved. Alistair Davidson is a strategic consultant with extensive experience in developing budgeting, strategic planning and business intelligence systems. He is a contributing editor to Strategy and Leadership magazine, author of three books on strategy and technology. His career includes developing numerous software planning systems and tools, in addition to facilitating business and IT strategies.
Contact information: alistair@eclicktick.com, +1-650-450-9011

Executive Summary
Developing a forecast or budget sounds like it should be a simple task.
It rarely is. A planning and budgeting process is often used for multiple purposes and has many stakeholders, each with his/her own interests, constraints, risk profiles, deadlines and commitment to the process. Often budgeting processes become a minimalist exercise that reflects the power of the CFO rather than a process that is useful to strategic thinking and strategic management in the organization. There is nothing worse than a budget developed six months prior to the beginning of the fiscal year that is out of date before the year has begun.

Developing a forecast or a budget is typically an iterative process. The number of iterations within a particular year will affect the perception of the value of the process (more iterations typically annoys people). Just as importantly, forecasts and budgets are exercises that will repeat typically at least quarterly and annually. They will always evolve over time.


Developing a successful forecast or budget requires five elements for success:

1. Senior sponsorship is required to ensure that cooperation is obtained from all participants.

2. The level of work imposed or solicited needs to be perceived as reasonable and appropriate, often a difficult task in a changing environment without good supporting technology.

3. Senior management should avoid using the forecasting process to educate themselves and causing significant workload on the numerous participants. This is best achieved by spending time up front to understand the workload caused by a forecast exercise.

4. A longer term perspective on the forecast should be addressed up front by analyzing the workload and number of pieces of data being developed for each forecast in the current and future periods. Perfect systems should be avoided and iteration anticipated.

5. The forecast should be strategic and focus upon critical issues rather than letting the apparent simplicity of spreadsheets drive linear extrapolations of past performance. Forecasts should explicitly address uncertainty and risk, capacity utilization and the process of forecast revision over the forecasting period.

Introduction: Why Is Forecasting Difficult?
Planning and budgeting (P&B)are basic tools in managing a business. Budgets are often used to control spending and set expectations. Forecasts are often thought of as revisions to budgets done on a periodic basis to make sure that the budget is compared based on more recent data. Forecasts often extend beyond the budget period as well. If you are doing a quarterly update, there is little point in a cycle of 9 month, 6 month and 3 month projections, it's often equally as easy to do a rolling 12 month forecast.


Forecasting is often a problem for a companies because it serves multiple purposes and the importance of these multiple purposes looks different to different stakeholders throughout the organization. In an ideal world, the designer of a P&B process would identify the key stakeholders (i.e. people or groups that make the project a success or block it) and identify their minimum requirements for the P&B project's success. Generally speaking a stakeholder will have a threshold that must be delivered for satisfaction and other elements which they want emphasized a great deal.


Let's examine the stakeholders for the process:

1. The Board of Directors typically expects a forecast so that they can determine the future performance of the company. Their bias is typically towards financial results and to a lesser extent risk management. Strategic issues are often downplayed particularly in diversified companies with many different business.

2. Senior management in the company often uses the budgeting and forecasting process to force the organization to make choices about allocation of capital budgets, operating budgets, new product development processes, sales and marketing efforts. Annoyingly for the developer of forecasts and budgets, the projections are often used as a way of educating senior management about the business leading to multiple iterations.

3. Middle management and financial functions in the organization often use performance against the budget and forecast to revise their activities to meet their goals and performance metrics. Just as importantly, they use revisions to the budgets to prepare other stakeholders for surprises. Failure to deliver a budget is frequently less of a problem than the problem of surprising a boss with a failure to meet a budget. The budgeting and forecasting process is often seen as a chore rather than a productive use of time.


A very common problem for managers is the design of and successful implementation of a planning and budgeting process. There are several key constraints that make the design process difficult.


First, most managers undertaking a P&B process have little experience in their design and consistently underestimate the effort involved.


Second, P&B issues change constantly. If the CEO or profit center owner decides something is important, it is likely to be dropped into a P&B process at the last moment causing significant work load to the implementers.


Third, planning systems often draw upon information in other systems and formal migration processes for designing, testing, rolling out and training users is weak. Integration issues and business intelligence issues are surprisingly rarely addressed even though the information used in a good P&B system is very valuable to many users.


Fourth, planning tools are often dictated by functional areas for their own benefit and don't consider other users.


Fifth, budgets for P&B systems are generally small. Custom work has to be shoehorned into short time periods without regard to the actual work required.


Sixth, year over year comparisons are often extremely difficult because the planning system varies from year to year. The consistent information is often not the most important information for operating managers.


Seventh, disagreement about the scope of planning is very common. Planning is a bit like the elephant in the apocryphal story about the six blind men and the elephant. It feels very different depending upon where you are relative to the elephant.


Diagnosing Your Forecasting Problems
Before you can improve your forecasting (and often before you can obtain cooperation from stakeholders), it's typically a good idea to seek to understand from stakeholders what past problems have occurred and what needs are going unmet.



Typical problems might include:

1. Poor accuracy in the budget or forecast
2. Time wasting revisions to the P&B data as stakeholder requests evolve.
3. Excessive manual work.
4. Irrelevance after the process has been completed due to the length of time taken, iterative approvals or changes in the environment subsequent to the development and approval.
5. Inappropriate levels of granularity i.e. budgeting at too detailed or insufficient detail (which we might refer to as the Goldilocks problem)
For each of these five problems, different solutions are available. The resulting P&B efforts and focus are likely to look different.


The Multi- Period Problem
Perhaps the most important problem with P&B systems is that they tend to be focused upon financial requirements and not upon customers. Consider the situation of a customer that buys a pilot project that if successful could lead to 10-100X more volume of purchases and significant profitability. However, if the subsequent profitable purchase falls outside the budget or forecast period, resource allocation decisions may cause underinvestment in developing pilot projects.


Customer profitability is rarely well represented by a single period view of a customer. P&B systems that only look at single year profitability may be missing the most important drivers of overall profitability. A software company that only looks at financial results can show revenue growth while in decline. If a healthy number of new customers are not being acquired, maintenance revenues may continue to increase but the competitive position may be deteriorating.


If the purpose of forecasting is to be useful, then the information base for the forecasting should be useful, relevant and flexibly capable of being modeled and changed.


The Multi-Forecast Problem
A common problem with P&B systems is that budgets and forecasts get revised. In theory, it should be easy to compare a budget with a revised forecast that is updated every three months. However, it becomes exponentially hard if the data is driven off detailed data and the detailed data does not exist on a quarterly basis e.g. a total market size number that is only revised annually by a tech consulting firm or if the forecasts have been inconsistent in their use of bottoms-up and top-down forecasting.


There are no easy solutions to this particular problem.


The Implicit Strategic Decision Problem
A common problem in forecasting processes is the hidden assumption that the forecasting process should force managers or enable divisional or head office managers to make resource allocation decisions while developing a forecast.
The challenge here is that budgeting and forecasting systems tend to be linear extrapolations of the past. Innovations, in contrast, are often harder to forecast and have higher uncertainty. As a result, plans and forecasts presented in a spreadsheet often seem to imply that each line of the forecast is equally certain and reliable.



The truth is typically otherwise.


And the more detailed the forecast, the more likely it is that each line will produce a variance in subsequent quarters. The solution is typically thought to be focusing at a high level of forecast that irrelevant or immaterial variances don't show up.


Infrastructure Issues

P&B systems typically cause the creation of spreadsheets and PowerPoint slideshows. More sophisticated systems have been developed for consolidating hierarchical budgets and forecasts. These typically fall into two categories - multidimensional spreadsheet or OLAP tools and relational databases. Because these tools are typically difficult to use, the reality is that most work is done in spreadsheets and then uploaded to consolidation tools.


However, it is not clear that these consolidation tools are helpful in the process of developing a forecast. Without going into the mechanics of building up a consolidation or reconciling a top down goal setting with a bottom up forecast, let's just say that it is messy and complicated. The result is that forecasts are often painful to develop and inaccurate.


Dealing with High Uncertainty - Scenarios vs. Business Success
In highly uncertain environments, there are four basic approaches to forecasting.


Multiple Forecasts
The approach used most often is develop multiple forecasts. A high, medium and low forecast is the most common version seen. A more sophisticated approach is to develop a probability weighted set of forecasts where each forecast is assigned a probability. Each forecast then results in an expected value that adjusts the revenue forecast by the probability of revenues. Probabilities add to up to 100% so that the sum of the expected values is the best estimate of revenues. The unattractive side of this approach is that while it is useful for revenue forecasting, it is less useful for many expenses as they will be adjusted to reflect different revenue cases. Another weakness is that research suggests that most managers underestimate variability and risk.


Monte Carlo or Stochastic Modeling
Spreadsheet based forecasts are typically characterized as deterministic. Monte Carlo modeling involves a more detailed approach to uncertainty. Each line in a forecast is mapped to a potential probability distribution (e.g. a normal or power curve distribution). A simulation is run hundreds or thousands of times to see the overall outcome distribution with each line item varying according to its probability distribution each simulation run. Because of the number of runs made and the need to map a distribution to each item in the forecast, more detailed consolidations are typically avoided in smaller companies and forecasts are done at a fairly high level of summary.


Scenarios
Multiple forecasts are often erroneously called scenarios. But more properly, a scenario is a term reserved for naming and describing a future in which the organization might have to operate. Scenarios represents ways of stretching the thinking of the organization so that the organizations anticipates the impact of a proposed strategy across a more diverse set of potential environments.


Resource Allocation Frameworks
Many organizations address resource allocation decisions separately from P&B processes. They may make resource allocation decisions within the P&B process, but they separate out earlier stages of resource allocation. Often these systems are characterized as new product processes, productizing processes (in service organizations where services migrate from custom to standard) and capital budgeting processes, where a limited pool of capital is allocatable to major investment projects via a formal approval process.


Thinking Outside the Box - What are you not measuring and not forecasting
It may seem strange to think about what you are not forecasting but well managed companies should look at what they are not addressing and the larger issue of how well an organization is doing in the overall environment.


There are several ways of thinking about this problem.


Some companies look at share of wallet or share of expenditures. They measure their forecasts as a percent of total spending by a group of customers. When forecasts are looked at in this light, companies can understand to what extent they are not obtaining revenues and profits from areas of the market where they have blind spots.


Another key measure that is important to look at is what is your addressable market vs. the total market. A forecast can often look good in the context of your addressable market. However, if competitors are making in-roads into the total market, you business may be in decline without you realizing it.


Benchmarked performance. International companies often have difficulty comparing markets. Having a benchmark allows for comparisons of performance that are independent of pricing, cost inputs and currency fluctuations. The publisher, Harlequin, used to look at books sold per thousand women over 18 per year as a measure of market penetration and maturity.


Capacity Management and Forecasting
Many organizations do a good job of forecasting revenues and expenses, but do a bad job of forecasting capacity and utilization. There are many reasons for this bias. It's difficult to forecast lagged variables such as hiring a person, training them and make them effective or processes whose cycle times are longer than the cycles times of marketing and sales. And developing people and capacity often needs to be done in advance of obtaining sales leading to a perception of risk, both in terms of internal evaluations of performance and financial outcomes.


The key task here is to make sure that assumptions are explicit rather than implicit and that the organization is committed to the marketing and sales objectives. By having clarity and consensus better decision are likely to be made and delivery failures are less likely.


Explicit decisions on training part time people can also be pursued to manage peak loading and capacity problems.

Summary
Planning and budgeting systems are more complex to design, specify and obtain compliance with than most managers anticipate. Making sure that sponsorship, scoping, evolution and links to the rest of the organization are considered early in the process will increase the likelihood of success.

Restricting Senior Executive Pay

In the past week, there have been numerous comments about overreaching by the Federal Government in placing caps upon the pay of the top twenty-five executives in companies that have received major government investment.

Government determining the pay of executives is clearly an overreach, but I find it hard to criticize the modest restrictions.

Consider the situation if these institutions were not banks, where bankruptcy was a legal option. Under such circumstances, every employee in the organization would likely be facing firing, salary and other reductions in remuneration.

Banks are difficult to put into bankruptcy because such events would trigger complex and cascading contract events, so the Fed, the Treasury and other regulators have been forced to take over these financial institutions in a "soft" bankruptcy.

When government involvement is looked at in this light, perhaps the complaint should be that more has not been done.

Commentary: Rules Matter and Foot Faulting is Cheating

On Sunday, I made a fuss on the tennis court. It's not something I like to do, but my opponent was so egregious in his cheating that I felt compelled to call him out. (By the way, I use the word cheating deliberately based on what the USTA states.)

Now, before I tell you my story, let me confess that I lose a lot of tennis games, but I love the sport -- the Zen of playing it. So winning is great, but it is not everything for me. So I am not motivated by gamesmanship. I enjoy the fun of tennis which is why I organize a regular game for two courts of players each weekend.

My opponent, let call him "S", started outside the base line, placed his right foot completely into the court (inside the line) and then pushed up from inside the court to hit his serve. He did this on every serve even when he had been called on a foot fault for the previous serve for the same fault.

He got angry, claimed I could not see his feet and insisted that he served way behind the base line. After four consecutive foot faults, he stormed off the court, very angry at me. All in all, it was not a pleasant experience for me. And probably not for him, either.

Coincidentally, I ended up watching S in a subsequent round from a position where I could see along the base line as if I were a line judge. Every serve repeated the pattern of stepping one foot completely into the court before rising up to serve the ball. What I realized is that S either does not understand the rules of faulting or he is not watching his own feet. A companion, a knowledgeable, long playing tennis player and long term organizer of tennis events, seated beside me agreed on my assessment. It was clear to both of us.

Now S has a strong serve and I like playing against people with strong serves. It gives me a chance to practice my service return. But, as Randy Cummings points out in his web site:

What does a foot-fault do? Think of it this way, it either lowers the net by a six inches or more or makes the guy serving equal in height to Ivo Karlovic. In either case, the server has a distinct advantage over the opponent who remains behind the baseline until after the ball has been struck. The cheater can hit harder, flatter balls, because with a lower net or higher physical stature he has more margin for error (see my articles Deceptively High Net and Window on the Serve for more explanation). If he is also serving and volleying, he is that much closer to the net before your return crosses into his half of the court, making his volleys easier to execute.

Why is this cheating tolerated? Probably because those facing the cheater don't realize how high the net really is and how much topspin needs to be hit on the ball in order for it to clear and land in the box. The net is deceptively low because you can see through it. If it were a solid piece of material, you would quickly perceive how much you have to arc the ball in order to have a safe serve. Failing to understand this, players allow the cheater to continue, not realizing how much advantage is really being taken by the foot-faulter. The foot-faulter has reduced the amount of arc he needs to have on the ball to get his serve in the box, giving him a distinct advantage.

http://vjtta.com/content/view/238/88/

This paragraph by the way describes the type of serve delivered by S.

To reinforce the point, the USTA states:

... And one of the most missed/ignored rules is the foot fault. Here’s a reminder from Sheila Banks, Director of Adult/Senior Recreation USTA/Pacific Northwest, reminding players of the foot fault rule and how to handle a team that is committing foot faults:

Please pass this on to your Captains as I have received concerns that many players are footfaulting during their matches.

Foot Faults are considered cheating and at no time to be allowed..

http://tenniscrowd.com/blog/2009/03/07/the-foot-fault-rule/

USTA Code p. 54/55

Footfaults: A player may warn an opponent that the opponent has committed a flagrant foot fault. If the foot faulting continues, the player may attempt to locate an official. If no official is available, the player may call flagrant foot faults. Compliance with the foot fault rule is very much a function of a player’s personal honor system. The plea that a Server should not be penalized because the server only just touched the line and did not rush the net is not acceptable. Habitual foot faulting, whether intentional or careless, is just as surely cheating as is making a deliberate bad call.

I have a pretty good serve some days. Some days not. Serving is difficult and we are all frustrated by days when our service is off. That same day of dealing with S, one lady came up to me and implied in a very gracious way she did not believe foot faults should be called. But there is very little point to tennis if we apply rules selectively. When should we bother calling a ball in or out? When it comes to foot faults, at what point do we call them, when the foot is on the line, inside the court, when the player is serving from three feet inside the court?

To be honest, I don't call most of the foot faults I see. There is a lot of social pressure not to. And there are a lot of them in weekend tennis. But if a player is a beginner or low rated player with a weak serve, I feel it's too much trouble to call.

But I am changing my view. I think we should call foot faults. In my research, the best conclusion I have come up with is to warn the person the first time and then call them on subsequent faults.

Not foot faulting is a good idea. It makes you less likely to foot fault in a tournament. It sets a better precedent for your kids. At the risk of being grandiose, in a world where large scale cheating has been occurring widely (Enron, Bernie Madoff and the whole financial melt down to mention only a few), perhaps not cheating has a larger value.

And if you are consistently hitting the net, maybe you should learn how to improve your serve rather than cheat. It's not that hard to learn how to put a little topspin on your serve which eliminates the need to foot fault.

I would like to offer a final mea culpa. In doing my research for this commentary and reading the rules of tennis, I have learned much more about foot faulting than I previously knew. I knew for example, from listening to commentators at tennis events, that your feet cannot intersect the center line of the court when you serve. I did not know you had to be inside the outside line when you serve. I also learned that you cannot be moving, either walking or running when you serve. I suspect I have been foot faulting when I served from too close to the outside of the doubles or tram lines. So, while I have never been called on a line foot fault, I suspect I should have been when I was serving from far too wide.

So, please, call foot faults. We can all benefit.

Chief Customer Officers and the Digital Living Room

The Digital Living Room still continues to fall between the cracks of the silos in organizations. Consider a recent experience with major vendors.

An evaluation HP Windows Media Server that I purchased recently for a project came with MacAfee for virus protection. The protection expired after the initial trial period of 7 months.

So, I decided to use Norton, which I use on my other machines. However, Symantec does not make it clear whether their products work on Windows Home Server. Nor did they reply to my support request. So, I decided to upgrade the existing MacAfee solution as the lazy man's approach.

After two support calls separated by three days, and after 50 minutes on hold, I determined on the second support call that the product currently has installation problems and also does not upgrade its data files. The conclusion was not shared with me on the first support call where a different answer had been suggested.

Now, as a past CEO of various software companies, I sympathize with the challenges of supporting continually changing software. And I am not particularly worried about this server, which is primarily used for file back up and music sharing.

But the whole experience of:

1. Having to determine whether a product works with a home server.
2. Inability to offer a clear and simple decision process on what to buy.
2. Confusing installation processes.
3. Difficult to use administrative software more appropriate for a small business than a home user.
4. Delivery of support via the small business support line causes unnecessary phone calls and downloads of support software.

reflects an inside-out silo'd view of the customer.

Persuading consumers to tackle the Digital Living Room will require a more customer centric perspective. A Chief Customer Officer would help a company transform the customer experience so that successful customers would become ambassadors on behalf of products and services.

Getting Sued

I recently had an off the records conversation with a former CEO of major firm who had spent much of his CEO tenure dealing with more legal suits than any business should have to deal with.

The take away from our discussion was that with the full benefit of hindsight, the company's problem was that (1) it was small, (2) its patented technology was really valuable to very large customers, (3) the company priced licensing of its technology based upon the value of the technology to licensors and their customers.

What the company forgot -- and this is a common mistake of small companies in the United States -- is that a large company looking at a small company always has the choice of litigating and use the law as a weapon to beat the small company to death.

So, when I work with small high tech companies and their business plans talk about barriers to entry including a patent, I will often grimace.

If the technology is unsuccessfully, nobody will care.

If the technology is successful, then the chances of being sued go up.

If the technology is exceptionally successful or useful, it's pretty much a sure thing that you are going to get sued.

Without major reform to patent law in the US - which is clearly needed -- there are no simple legal answers to this problem, except to using pricing as a tool.

Pricing can encourage licensing and make it more attractive than suing. What people forget is that there are many ways of pricing a product. Pricing creativity can reduce legal risk, accelerate revenues and in some cases increase total revenues.

It's worth thinking about before you get sued.

The Digital Living Room - Miles to Go Before You Can Sleep

Yesterday, I attempted to watch a Blu-ray movie obtained from Netflix, produced by Sony studios, on a six month old Sony Vaio multi-media laptop, hooked up to a 25.5 inch Samsung monitor as a secondary monitor. Blu-ray of course is a wonderful standard for high def movies developed by Sony.

It took me two hours and two support calls to get the movie started.

Now it's pretty hard to argue that compatibility should have been an issue with Sony controlling all the technology. If I were not doing consulting to firms in the digital living room area, I would have broken something in frustration. I rarely get so annoyed by technology that I curse out loud, but it was one of those evenings.

So, you may ask, what happened?

The problem began with the InterVideo software shipped with the notebook. When I stuck in the Blu-ray disk, it told me that I need to renew a key in the Blu-ray viewing software. I was sent to a confusing page with the software vendor Corel, a relationship I was unaware I had. My immediate thought: is this some kind of virus problem? The key transaction then failed twice. So far ten minutes wasted.
The courteous and knowledgeable support person in Costa Rica talked me through disabling user account control on my notebook and obtaining a key upgrade. I was fuming by this stage. Not only do I object to an unnecessary key renewal, the software does not even work well. So far, 60 minutes wasted.

But the problems did not stop there. I could not escape the previews on the DVD. Now, I would like to think I am a pretty knowledgeable about the digital living room. People hire me to look at their products and do competitive comparisons. But it was practically impossible to get to the movie. I think I saw the previews seven times. Unlike most people I have two media computers with Bluray from different vendors. Same problem on both my desktop and my notebook. Total time wasted now at around 70 minutes.

On the second support call, we determined that a second Netflix Blu-ray disk, immediately went to a main menu from which you could play your movie easily. Admittedly, the second disk did reveal I had a bad setting on my desktop, causing the colors to be wrong, which I eventually fixed by letting the video app control color settings. The conclusion from the second support call was that the Blu-ray disk was defective.

Now, I am not a typical user. I am way more persistent. I eventually figured out a way of getting to the movie with some additional experimentation. Total time invested over the entire evening ended up at over two hours. But I would have to say that the experience was ridiculous. A media notebook that can't play media. A Blu-ray disk that won't let you get to the movie on it. Disappearing menus. Software that won't let you play your movie on your external monitor. Multimedia computers that have non working registration software that prevent usage.

Is Amazon the Most Interesting Media Company in the World Today?

The move to digital content has to a large extent was initially spearheaded by Apple. It's initial focus on its business system was on simplicity. Pricing per track was set at 99 cents. Simple and understandable. A good pricing model for a new and complex technology.

But today, the world looks quite different. Digital music is now mainstream. And with mainstream businesses, traditional retail issues and innovation start to become more important.

Amazon is at the forefront of this new trend. It is a result, possibly the most interesting media company in the world.

Consider the following:

Amazon sells traditional books, electronic books on Kindle or iPhone/iTouch, traditional physically delivered music, downloadable MP3s, new and second hand DVDs, downloadable movie purchases and downloadable rentable movie viewing. Other than a subscription model, Amazon has most of the purchase options covered.

Even more interestingly, unlike Apple, Amazon is behaving like a smart retailer. It uses free songs, free Kindle copies of the first book in a series to create traffic, in a way analogous to the supermarket offering cheap milk to bring in customers or samples to get customers to try a new brand.

And Amazon is testing pricing. It offers daily specials pricing anywhere from 99 cents to $2.99, with $1.99 as the most common price point to encourage traffic, obtain sampling and give customers a reason to keep coming back every day to their web site. It's better than advertising, because revenues are produced by the hook that pulls in the customer. And of course, the big problem with an ecommerce site is getting traffic. If they visit, you have a chance of selling them something.

But the really interesting capability that Amazon is building is deep understand of individual customer tastes and price elasticity, something that Apple has spurned. Amazon is learning about the tradeoffs that individual customers make on different types of purchase, lease or download of content. When will a customer own or rent? What do you need to do to create trial? When does it make sense to discount to trigger additional purchases of content from a writer or artist, or to addict a reader to a book series?

Great businesses don't freeze their strategy. They continually improve them. Amazon seems to be aggressively learning faster than other players. Kudos to them.

To Pareto or Not To: Changing the Profitability of Your Business
Copyright Alistair Davidson, August 2009 as an unpublished work. Alistair Davidson is a strategic consultant with turnaround experience who has been CEO of several companies and helped companies improved their revenues and business development activities.

Contact: alistair@eclicktick.com Phone: +1-650-450-9011

Certain key insights in strategy seem to be continually important. Flanking a competitor is often a better strategy than attacking them head on is one example.

In many business and economic analysis, 20% or so of a market, customer group or products seems to account for a disproportionate result, often characterized as 80% of the results sought (revenues, profits, etc.). This Pareto or 20:80 rule became very popular in the 80s when activity based costing exercises revealed that for many companies profitability was driven by a small number of customers. The less intuitive conclusion, one that frequently has to be explained to first time readers is that if 20% of your customers account for in excess of 100% (say 150-200%) of your profits, then the you are losing money on the other customers.
What is challenging about the Pareto insight is that it offers a universal rule of thumb, frequently and consistently important, but the prescription from the insight is often less obvious. And sometimes it is wrong. The Pareto insight leads to one of two conclusions:

1. The 20% of customers represent a unique group and lessons learned from them are not directly applicable to the rest of the market.

2. The 20% of customer represent a model for my future business.

Business Model Revision

The Pareto rule is often difficult to apply is where a new business model is introduced. It is never 100% clear whether a potentially disruptive technology at the low end of a market will change market requirements or provide a platform for an initial insignificant competitor to build upon. In a parallel way, migration of high end features from premium products and services to the mass market is also difficult to predict in some markets.

The concept of Track and Trace (making parcels and envelopes trackable though out the logistics process), offered by FedEx and UPS was extremely threatening to the Canadian Post Office. They could see no way of matching the capability given the volume of mail and packages they delivered.

The internal debate revolved around whether they should take a Pareto approach and focus a Track and Trace capability only on parcels and high value added packages, or whether this would be a long term capability for all logistic operations. Their eventual conclusion was they needed to have more presence in the premium package and envelope business and Track and Trace would largely be restricted to the high end of the market. To this end, they bought a courier company, Purolator.

Dropping Customers

One potential prescription from learning that 20% of your customers account for 150% or more of profits is to slim down the business and focus upon the profitable customers. However this strategy is often emotionally very difficult for many managers and often pursued too late. Managers have spent so much time investing in acquiring customers that given up the customers is distressing.

Raising Prices

Raising prices for the less profitable customers seems like an obvious solution to a 20:80 insight, but resistance from the sales force, inadequate systems for tracking discounting behavior and negative feedback from customers are likely barriers that will need to be overcome. Slightly more clever approaches change the basis of pricing in ways that are more palatable to customers. Leasing and usage based pricing are particularly attractive to capital constrained customers and change the nature of the evaluation process.

Reducing the Cost of Delivery for Unprofitable Customers

Financial services organization frequently have used self service with ATMs and online banking to reduce the cost of less profitable services and less profitable customers. In contrast, wealth management services offer higher levels of service and advice.

Reducing Marketing Costs

A less obvious approach to making many customers profitable is to delight customers so that they become your sales agents. Strong word of mouth can significantly reduce a required marketing budget. Amazon uses daily specials in e.g. the MP3 download market to encourage daily visits to their site, a low cost way of generating traffic. Heavy users may tell their friends about hot music they have found a deal on.

Life Cycle Management

As with most costing decisions, it turns out that pricing is often a strategic decision. As a result, the time frame over which you measure customer profitability is critical as are the implications for organizational capacity.

• Mature software companies like Oracle will often discount their software significantly to obtain sales (with the largest discounts occurring at quarter and year end when sales reps are under pressure to meet their goals). Part of their willingness to do so, is their knowledge that software is actually more a service than a capital expenditure with maintenance revenues a critical part of the annuity relationship with a customer.
• The success of the Apple iPhone is based in part upon the fact that that a $600 cost of purchase by AT&T is resold to a subscriber for $200 in return for a two year contract that might add up to $2400 of revenues and a strong probability of retention at the end of the contract. These high ARPU (average revenue per user) clients are likely some of AT&Ts most profitable.
• The challenge for AT&T is to how to grow their business. Are these customers atypical, i.e. a 20% that is atypical or do they represent a different business. Research suggests that there is a large gap between the number of subscribers that would like an iPhone-like service (i.e. with easy to use Internet access) and the actual number of data subscribers. One interpretation is that subscription rates would increase with lower data plan prices. A move in this direction would have significant implications on network architecture for AT&T mobile network capacity by reducing the revenue per user from data plans and lowering revenues per byte transmitted.

Increasing Value Propositions

Bundling is one example of changing value propositions. Companies like Hyperion (now Oracle) and Microsoft have used bundling to reduce the cost of individual applications, but create more value for customers. In telecom, triple and quad plays (combination of voice services, broadband, TV services and mobile services) are a common marketing approach.

In some ways, bundling can be slightly unintuitive. Most purchasers of e.g. MS-Office probably don't use most of the features they purchase, but the incremental cost of having compatible features available has value. Most fixed rate pricing programs e.g. Netflix make this same tradeoff. Netflix may lose money on some customers who are heavy users of the service, but the reality is that most people are at or close to the limits of time they can devote to viewing videos. Value perceived is not necessarily usage.

Changing the Basis of Competition and Cost of Delivery

The Pareto insight is one that many companies are facing in the current recession. When demand for a product category drops dramatically, downsizing assumptions are often affected by assumptions about demand and profitability distributions.
In the automobile industry, the politically unspoken "elephant in the room" is that gasoline prices will in the future be maintained at a far higher level than previously for reasons of balance of trade, security and global warming. This increase in the total cost of ownership of a car will make likely make small cars more popular and more expensive than they have been historically. It will also make driving more expensive reducing total demand for cars. Auto companies are faced, as a result, with downsizing, a cyclical downturn of unusual size and a longer term secular shift in purchase patterns.

As with many markets, the automobile market is likely to become far less homogenous. The market may evolve towards predominantly electric powered microcars for in city driving, hybrids for trips requiring greater range, and larger hybrid capacity vehicles for transporting larger groups of people.
For automobile companies, their cost structure, traditional assumptions about profitability, scale and scope economies are all open to question.
In the same way, telecom service providers faced with demand for low priced unlimited data plans are having to rethink their network architecture to divert home and office data traffic away from cell towers to home fixed broadband connections.

Summary
The key take-away from any Pareto analysis is that it is a useful rule of thumb that inspires important questions about making money in your business. Making the right decision means not only looking at product and customer profitability, but also your delivery process and value chain from the perspective of both current and emerging usage patterns.