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FUNDAMENTALS OF ECOMMERCE: THE 80/20 RULE
Throughout life, outcomes appear to be disproportionately driven by a surprisingly small number of inputs or causes. In this post, therefore, we explore the following:
- What is the so-called 80/20 rule?
- How does the 80/20 rule apply to eCommerce?
- What are the implications of the 80/20 rule for eCommerce?
WHAT IS THE 80/20 RULE?
The so-called 80/20 rule (commonly referred to as the “Pareto principle”) holds that 80% of observations tend to be driven by 20% of causes. Mathematically, the 80/20 rule takes us away from the comfortable confines of normal distributions (with their perfectly symmetrical bell curves) to the heavily-skewed world of power laws (often referred to as “Pareto distributions”). Such distributions appear to be widely applicable in both the physical and social worlds: from physics and biology to economics and finance.
HOW DOES THE 80/20 RULE APPLY TO ECOMMERCE?
In eCommerce, the 80/20 rule has a tendency to (roughly) show up in several core areas:
- Product offerings
80/20 Rule: Customers
Management and marketing experts have long been aware that 80% (+/-) of sales tend to come from 20% (+/-) of customers; however, neither the nature nor the importance of the relationship appears to be widely recognized by practitioners. On the business-to-business (B2B) side of things, these key customers tend to be easily identifiable – they often number five or fewer and both individually and collectively carry a vastly disproportionate load of the total sales revenue of a typical eCommerce business. On the business-to-consumer (B2C) side of things, these key customers are similarly easy to identify – they tend to buy frequently, spend greater amounts of money per order, and are likely members of rewards and/or other VIP-based programs. Beyond sales revenue, the 80/20 rule also seems to hold up well when it comes to customer profitability – though the respective rank orderings of the largest and most profitable customers don’t always fully overlap (this is an important point – more on this later).
80/20 Rule: Product Offerings
Interestingly enough, eCommerce sales revenue and profitability both tend to be disproportionately driven by not only a select group of customers, but also by a select number of unique product offerings (SKUs) – though, again, the rank orderings of SKUs by sales revenue and profitability don’t always overlap. At IronLinx, we actually structure picking and packing for our customers based on the 80/20 rule – with the fastest-moving SKUs placed closer to packing areas (to reduce handling time) and periodic re-evaluations conducted to re-optimize as things change over time.
80/20 Rule: Marketing
Many successful dropshippers seem to at least implicitly understand the 80/20 rule as evidenced by their never ending search for winning products, copy, and creative – all three of which are needed for effective (and profitable) scaling. As a whole though, the 80/20 rule seems to be broadly applicable to eCommerce marketing as the bulk of both sales revenue and profitability tend to be driven by a small subset of sales channels, ad variations, and marketing strategies.
WHAT ARE THE IMPLICATIONS OF THE 80/20 RULE FOR ECOMMERCE?
What does this all mean for eCommerce sellers? Quite a bit:
- In terms of sales and profitability, the 80/20 rule underscores an obvious but harsh truth: not all customers are created equal (from a business perspective). More often than not, there tends to be a small subset which contributes a level of profitability critical for both survival and success — naturally, it is these customers who deserve the bulk of a business’ attention and resources. There also tends to be a larger subset of customers that is somewhat profitable – accordingly, its members should get adequate attention, but assuming resource-constraints, materially less than those described above. Finally, there tends to be a third subset of customers that contributes the least (and often generates net losses on a customer-by-customer basis) – such customers should be politely pointed in alternative directions.
- In the B2B space, the largest customers by sales revenue aren’t always particularly profitable. For such customers, sellers must balance the potential benefits to be gained in terms of purchasing power and brand recognition with the potential costs associated with heavy customer concentration, any attendant receivables risk, and forgone opportunities due to resource constraints.
- As far as SKUs are concerned, the small subset that does most of the work should always take priority when it comes to purchasing, advertising, etc. When economically feasible, consistent testing to discover new winning items is strongly encouraged; however, sellers should be sure to frequently re-evaluate existing SKUs to cull out those which generate little but take up valuable resources (shelf space, online positioning, inventory and marketing dollars, etc.)
- Keep in mind that some SKUs may do a lot of work in terms of generating sales revenue (directly or indirectly), but lag when it comes to profitability. For such SKUs (often referred to as loss leaders), sellers must balance the potential benefits to be gained in terms of conversion rates, average order values, and purchasing power with the potential costs associated with poor unit economics and foregone opportunities due to resource constraints.
- In terms of marketing, the 80/20 rule certainly encourages experimentation (that breakthrough ad really could be on the horizon); however, it also provides ample reason to take a step back, recognize which facet(s) of a marketing plan is/are doing the bulk of the work, and redeploy resources accordingly.
In a world where resources are abundant, the 80/20 rule is less important; however, as the average eCommerce seller is plagued by resource-limitations, its lessons should be carefully heeded.