Blog, Pricing

The Underrated Pricing Power of the Pareto

By Justin Bailey
December 11, 2018

As I look across the breadth of industries that Vendavo supports, I see a vast spectrum of pricing strategies and organizational priorities. Some companies are simply trying to begin their journeys by focusing on basic operational topics. Other trend setters are embracing truly transformational topics such as outcome-based pricing and omni-channel customer engagement. It is an exciting time in the field of pricing, for sure.

Given the diversity of each company I work with, it would be easy to assume that learnings with one does not transfer to another, or that the complexity of one company’s business is unique. While sometimes I encounter true surprises, more often than not, great progress and financial benefit can be amassed simply by focusing on the fundamentals. Leveraging a Pareto analysis for basic segmentation and pricing is one such tool.

The 80/20 Rule

Most people have some familiarity with a Pareto analysis due to its colloquial form, the “80/20 rule”. Written as such, this is commonly understood as “80 percent of the benefits come from 20 percent of the causes” and it’s justification for prioritizations throughout life and business. The pervasiveness of the 80/20 rule is a credit to how often its works out to be true, at least directionally.

A Pareto-driven price segmentation approach uses the 80/20 concept, but makes its mathematically precise. Imagine a table of all of your customers, with each row corresponding to a unique customer. Furthermore, imagine you also have the past year’s annual revenue for each of these customers in that same table. Now, sort the rows in descending magnitude of the annual revenue. Your largest customer will now be at the top of list, while many tiny customers populate the bottom of the list.

Here’s where it gets interesting…. Take the TOTAL revenue for the past year, and divide by 5 to obtain a revenue quintile (5 segments tend to work pretty well for most, but you could opt for another number). Then, beginning with your biggest customer and working down the table, solve for the cumulative revenue. Any customer whose cumulative revenue is less than the first quintile is an “A” customer. Any customer whose cumulative revenue is greater than the first quintile but less than two quintiles is a “B” customer. This process continues until you’ve identified the “C”, “D”, and “E” customers as well.

Power of Segmentation

You will find very few A customers, slightly more B customers, and a great many D and E customers. Your A and possibly B customers will be everyday names, possibly with dedicated account teams, and they receive the lion share of IT and managerial focus. Many of your C, D, and E customers, on the other hand, you have never even heard of. This is perfectly normal. More importantly, this group is an opportunity for pricing strategies that will resonate with both your sales team and management.

By respecting the energy and effort that’s already been invested in your top accounts, this segmentation frees pricing to more aggressively pursue value capture on smaller accounts from a target pricing and tighter deviation controls standpoint. Because we’ve divided the total revenue in the business evenly across 5 segments, you will see the majority of transactions and money most likely resides across your Cs, Ds, and Es. These are the customers pricing typically can most directly affect, although proper attention must also be given to supporting the As and Bs and their corresponding account teams.

I’ve walked through an example of customer segmentation, but the concept of Pareto driven segmentation can be carried even further. For example, imagine segmenting your customers based upon their buying behavior for each product family you sell. You could even do this within separate geographies or some other peer group. Now that we have a way to fairly assess true market pricing from opportunistic purchasers; proper price targets and controls are only one more step away.

As you evaluate your own “80/20” of effort, I’d encourage you to include a proper Pareto methodology into your assessment. Time and time again, I’ve seen its utility pay dividends and I believe you will too.

For more information on how to build segmentation models that inform deal price guidance and maximize margins, see Vendavo Segmentation Manager.

  • 80/20 rule , Pareto analysis , price segmentation

    Justin Bailey

    Justin drives superior returns for his customers by delivering pricing and CPQ best practices. He brings over a decade of experience in business analytics, B2B pricing strategy, and managerial consulting to the Vendavo team. His diverse pricing experiences span everything from fabricated precious metals to medical laundering services, and he leverages that breadth to help his customers succeed with their unique pricing challenges.