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It Pays to Heed Pareto's Law

by Alan Darling

-Originally published in D & B Reports, a Dun and Bradstreet magazine.

"While they should be examining a segmented profit and loss statement each month, they bury problems under masses of numbers instead. The prime directive is to stop believing that big is better."

It seemed as if the Turco Manufacturing Co., a recreational equipment manufacturer in Du Quoin, Illinois, was in pretty good shape in 1978. 1976 had been the most profitable year in the firm's history, with sales exceeding $30-million, up from $12-million in 1975. When profits had dropped in 1977, Robert E. Feigenbaum, the firm's president, wasn't too concerned; Turco was growing and still making a profit. But in 1979, although sales increased once again, to $33-million, the firm posted a loss. Feigenbaum began to worry.

Giving the reins a solid yank before things got out of hand, he called in Jerry Goldress, a turnaround specialist based in Encino, California, and the two of them took a long, cold look at the company to determine its strong and weak points.

Rather than examine the business as a whole, they broke it down into its component parts and analyzed them individually. In so doing, Feigenbaum and Goldress discovered that quite a few of the products that Turco was manufacturing were profitable. However, they learned that quite a few others were costing them money to make. Some of Turco's customers were valuable; again, others were costing them money.

Turco cut back on the losers. Their sales volume dropped in 1980, yet they made a profit that was large enough to offset the previous year's loss. In 1981, their volume started to grow once again, but this time, profits rose as volume did. Today, they are a $55-million-plus firm with a healthy profit.

Pareto's Law at work

What Turco discovered was that Pareto's Law had been at work without their knowledge.

Vilfredo Pareto was a 19th-century Italian economist, known for his application of mathematics to economic analysis. His law states that 80 percent of the key outputs will be directly attributable to 20 percent of the key inputs. That is, 80 percent of the grievances will be filed by 20 percent of the employees; 80 percent of the sales will come from 20 percent of the sales force; 80 percent of the profits will usually come from 20 percent of the product line. To improve efficiency, the company should concentrate on this top 20 percent which is generating 80 percent of the gains. Products that are not among this top percentage (the ones responsible for only 20 percent of the sales) should be examined; they may not be worth the time and effort being invested in them. If each facet of a company is broken down and studied with Pareto's Law in mind, efficiency should rise.

In 1979, Turco had six product lines, two of which - a backyard playground equipment line and a line of gas barbecue grills were responsible for 95 percent of sales. The playground equipment had been Turco's bread and butter for years, but the industry as a whole had declined by nearly 50 percent during the 1970s. Turco felt they would have to become an industry leader to remain in the business, so they cut prices. Volume grew, but profit margins shrank. In 1979, this line comprised 35 percent of Turco's business, but was a loser as a whole.

However, when the playground line was analyzed, Turco discovered that it wasn't a total loss. Sears and K-Mart, their two biggest customers, were buying over 80 percent of Turco's playground equipment; the other customers were creating more headaches than profits.

Too many special products

"When there's an oversupply in the industry and you're scratching for volume, you sometimes take on things that you shouldn't," says Feigenbaum. "We took on business that we really shouldn't have taken. A customer would say, 'Make an item special for me.' We would make if for him, and he would say, 'I'm going to use 2,000 pieces.' He'd end up using 1,000, and wouldn't take the other 1,000. What can you do?" asks Feigenbaum rhetorically. "You can't go out and sue everybody you do business with."

So Turco had a huge inventory of playground equipment which they couldn't sell to their bulk- buyers because each lot was a little different from the next. Turco decided to get out of the playground equipment business, except for Sears and K-Mart, and determined to concentrate on their gas grill line, which they had first marketed in 1975 and which seemed to have the best future.

At that time, gas grills represented 65 percent of the company's business, and the line had become very broad. Turco was manufacturing several different sizes of these grills and was making several different models in each size. When this product line was segmented, Turco again found that some models had to go.

"One of the major problems a manufacturing company has is the proliferation of their product lines, and Turco's gas grill line was a good example of that," says Goldress. "They had too many different models within each basic size. That's expensive, and that makes you the high- cost producer. The reason they were doing it," he continued, " is that everybody wanted a grill that was a little bit different than their competition's. Turco found, through experience, that they really couldn't afford to do that, so they eliminated a lot of the special models. They went more to basic, standard models."

Getting rid of losers

In addition to their two main lines, Turco had four minor products that were accounting for 5 percent of their business. Of these, only the weight benches, which they manufactured on an ongoing contract basis for Sears, were profitable. The others - a baseball batting practice game, bar-type counterstools and scooters - comprised only 2 percent of Turco's sales and were losers.

"We said, 'You know something? This was a mistake from the beginning,'" Feigenbaum recalls. "'We're like a fish out of water. We're in a business we're not really in.' We got out of that. We took our licking and walked away from it. They were taking our attention away from someplace it should have been."

During this analytical process, companies usually discover that their actual strengths have been hidden to them. Turco found that although they billed themselves as manufacturers, their true strength lay in their ability to sell. They had a sound marketing program; they had a good knowledge of their market and very good sales representatives. Turco turned their approach around. Rather than sell only products that they could manufacture, they began to look for new products that they could sell successfully, whether they manufactured them or not.

Know your strengths

"Ninety percent of the time, a company doesn't know what its strengths are," notes Goldress. "All turnarounds are strategic. You never go through a turnaround by just working harder or doing more of the same a little bit better. If a company is not doing well, you need to change your strategy in some form or another. Usually, it's a whole combination of things." For example, Goldress continued, "at Turco they did, in fact, lower their costs significantly. They manufacture much better now; they purchase much better. But if you were to ask me what the real key to the turnaround was, the key was that they went from being a manufacturing company in philosophy to a method-of-distribution type company."

By 1981, Turco had stabilized and was making a good profit. They then put the new strategy to work. Turco managers went to Japan and worked with the Japanese to help them create the first portable kerosene heaters to be Underwriters Laboratories approved, and then began to import them. The kerosene heaters caught on quickly in the United States and just as quickly became Turco's biggest product. Today, they account for 60 percent of their total volume.

Managers must be objective

Before any company can be improved, the managers must be willing to look at it objectively. They must be prepared to cut their losers, regardless of the appeal that these losers may hold for them. Too many businesses are deluded by the idea that they can reclaim past victories.

"The key is to move from the weak over to the strong," says Donald Bibeault, a San Francisco turnaround consultant whose book, Corporate Turnaround (Corporate Turnaround: How Managers Turn Losers Into Winners by Donald B. Bibeault McGraw-Hill Books, 1981), examines more than 80 losing companies that became winners.

"People in this country love to rehabilitate things," notes Bibeault. At one heavy equipment manufacturer, the top 20 percent of the company's dealers were responsible for 60 percent of its sales, and the bottom 20 percent were doing only 3 percent. The bottom 20 percent had suffered a 40 percent decline in sales during the previous five years. The top group had actually increased its sales, and was responsible for 93 percent of the company's profits. If you spent all your energy trying to restore the bottom group to their former glory, they would still give you only 5 percent of your sales." And he adds, "You'll find that during weak economic periods, the weak will get weaker and strong will either get stronger or won't fall as fast."

The biggest shortcoming

Bibeault finds that this refusal to weed out weak elements is the biggest shortcoming of a losing company. Usually such firms prefer to avoid looking at their problems. While they should be examining a segmented profit and loss statement each month, they bury problems under masses of numbers instead.

"People like to look at great big averages, even though they may be losing $5 a ton on what they produce. They like to say, 'Well, we've got 2,500 products, and we're losing so much per ton of steel, or whatever. We're in a loss position, but we don't know what to do about it. It's the Japanese competition or the cost of energy that's causing the problems.'"

"When you develop an easy way to cost it out, you find out that on this product, you're making $100 a ton and on this product, you're losing $100 a ton. It's a difficult psychological process, but it's not a difficult mechanical process. People resist it. They almost don't want to find out. My God, they're going to find 400 products that they're not making money on."

"That's why they get in trouble," Bibeault explains. "They grow emotionally attached, and they don't look at the company the right way. They don't have the right information. Then, after you show them why they have a bunch of losers, they start rationalizing why they ought to have all those products."

A popular excuse

One excuse often voiced is that cutting back will cost the firm customers - customers who buy the winning products in addition to the losers. "That's what I call the fallacy of the full product line," says Goldress. "You make money on product A, you make money on product B, and you lose money on product C. The marketing people tell you that you must sell product C because the same people who buy A and B also buy C, and if you won't sell them C, they'll go somewhere else to buy A and B, and A and B are the bread and butter of the business."

Goldress cites another case where getting rid of losers paid off handsomely . Two partners acquired a 12-store, $12-million retail drug chain in southwestern Pennsylvania that had been unprofitable in the past. They hoped to build it into a 50--store chain. Although they knew that some of their stores were unprofitable, they kept them all open. Since they were building the chain, they wanted the name recognition that the unprofitable stores would provide, and they programmed for a small loss during that first year.

At the end of their first year they had added two stores to their chain, and their small loss had turned into a very big one. They called in Jerry Goldress, and a simple store-by-store segment analysis made their problem evident: Three of their stores were definitely losers. They had poor locations and would always be losers.

These stores were closed. The chain's volume dropped during the following year, but it stabilized financially. The chain now builds by acquiring small chains of three or four stores that can be bought cheaply. The unprofitable stores are shut down, and the profitable stores are added to the chain. Today, there are 22 stores, none of them losers.

"Keeping those stores open to foster name recognition was simply a losing strategy," says Goldress. "Even though you may be trying to build a geographical area image, the amount that you gain by that is more than offset by the losses in the store. You're better off shutting down losing stores."

Bigger isn't always better

Periodically, every business should do some self--analysis, and rid itself of losers. The profit and loss statement should be finely segmented and should be examined monthly, whether the firm is losing money or not. The prime directive is to stop believing that big is better.

"There is a cult of size in the United States," says Bibeault. "If your product line is 1,500 products instead of 2,500 products, it means you're a smaller company, They'd rather be grossing $40-million and losing on some of them than be a $20-million company making all kinds of money."

"A lot of people play the volume game," adds Feigenbaum. "If you're doing $100-million worth of business, you're a big-time operator, and if you're doing $50-million, you're not as big a big-time operator."

" I find great happiness looking at a balance sheet that looks pretty good," Feigenbaum says.

Copyright 1983 by Alan Darling

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Copyright 1996 to 2017 by Alan Darling Consulting