1 Nov 2005 apenwarr   » (Master)

Roadblock Analysis and the 80/20 Rule

I've written down this theory a few times in a few different places, but I still don't think I've explained it clearly. Here's another try.

For years people have been talking about the magical 80/20 rule of business: that 80% of your revenue comes from 20% of your customers, so you should find out who that 20% is and focus your attention on them. When you do, you magically make more money.

Nobody, of course, has ever offered me any evidence of this; only, "Wherever you look, it always turns out to be true. It did for us." This is suspicious, because it implies a selection bias, in which people have a natural tendency to only look for evidence that supports the specific thing they're trying to prove. For example, in the 80/20 rule, the 80 and the 20 measure different things; they don't have to add up to 100%. The 80/30 rule or the 90/40 rule are just as plausible as the 80/20 rule, lacking any additional evidence.

But I'm willing to accept a weaker formulation: the majority/minority rule. The majority of your revenue comes from a minority of customers. There are all sorts of reasons this might be true, most obviously the fact that most customers are small and therefore a few larger customers add up to more money than a few smaller customers.

Roadblock Analysis

I recently learned a rule, obvious in retrospect, that is critical to understanding business. Let's define a "roadblock" as a convincing reason not to buy. In that case the following must be true: no customer will buy your product until you eliminate all of his roadblocks. How do I know? If you invert the statement, it's obvious: if there remains a convincing reason not to buy, the customer will be convinced not to buy, by definition, and so will not buy your product.

This is important: if you solve 90% of the roadblocks for 100% of people, you don't have 90% of people buying your product; you have 0% buying your product. "Roadblock analysis" is my name for a process that I certainly didn't invent: the process of identifying a group of people (a "market segment") and the complete list of their roadblocks.

Now, in reality, people's needs are distributed randomly, and your features are distributed randomly, so some people will have their roadblocks solved just by random luck. But not most of them.

Note that roadblock analysis, unlike the 80/20 rule, is not magic: it's just a simple, logical statement. If you do eliminate all the reasons not to buy your product (remember, many of these reasons are non-technical, such as "I've never heard of your product"), then they will buy your product.

Why 80/20 Works

Once you understand roadblock analysis, you can understand why following the 80/20 rule (whether it's precisely 80% and 20% or not) actually helps. It's like this: the current customers who actually make you the most money are the ones who currently have zero roadblocks for many of their situations. The others are the ones who currently have more than zero roadblocks, at least for most of what they do.

People known to have more than zero roadblocks might in fact have lots of roadblocks; maybe hundreds of them. Who knows? But people who already have zero roadblocks in many cases probably have near-zero roadblocks for a bunch of other related things. It just makes sense; they probably do a lot of similar things, so if there are many situations where your product fits, and some situations where it doesn't, you can probably improve just a few things and solve those problems too. Not so with the other 80% of customers; for those, by default, you should assume you're nowhere close.

80/20 is a Random Process with Convergence

Repeatedly following the 80/20 rule causes you to converge on the closest market segment to the randomly-selected customers you originally chose.

That is, you start off by spamming the market with a technology-driven product that does something cool; you find out who buys it; you optimize it for those people; you find out which of those people buy it; you optimize it for those people; and so on. This is a feedback control system which will eventually converge on the local maximum market segment. Notice how the 80/20 rule, by focussing on a smaller and smaller subset of customers each time through the loop, decreases the "hop size" each time. This is a well-known technique for guaranteeing convergence. As we know from calculus, this kind of method works pretty well: but the local maximum is often very different from the absolute maximum.

Characteristics of 80/20 Solutions

The 80/20 rule is a major management fad at the moment, presumably because it works much better than completely random guessing about which customers are important, which is what most companies would resort to otherwise. After all, a simple mathematical method that gives a very high probability of making an existing product even more profitable is nothing to sneeze at.

But 80/20 solutions will show some very specific tendencies, which you can see all around you by looking at your favourite companies.

- The tendency to annoy about 80% of customers by ignoring or mistreating them. (In this case, the 80% is real, because companies define their strategy by literally choosing the 20% of customers they will care about.)

- The lack of new customers. By focussing on very specific existing customers and never implementing features someone else might want, you limit your ability to attract new ones and slowly get further and further away from other market segments.

- The irresistable tendency to move "upmarket." The one thing this algorithm guarantees is that when you have one big company and one small company as a customer, the big company will always win. There's no way any one small customer can land in the top 20% of your revenues. So you get more successful only as you serve fewer and fewer bigger and bigger customers.

This leaves a badly underserviced 80% vacuum at the low end, which in the software industry is basically the "small business" market.

The Missing Markets

Roadblock analysis is a more general method than 80/20 for finding and servicing a market, based on one important insight: there might be a huge market that you completely cannot serve right now because you left all of the customers in that market with a few, actually rather simple, roadblocks. These customers aren't in your top 20%, because all of them have problems.

The roadblock analysis method is much more risky than 80/20, in fact, because it's hard to know the list of all roadblocks you have to solve. It might look like there are only a couple of them, but after solving those, you might discover a dozen more. 80/20 gives you a virtually guaranteed path to expansion, albeit at an unknown pace; roadblock analysis guarantees nothing, but offers higher potential gain.

The Best of Both Worlds

Finally, the good news: if you explicitly choose a market segment using roadblock analysis, you can then use a variant of 80/20 to improve your performance inside that market segment.

In math, this is like choosing a better initial value for your convergence algorithm; if you give your algorithm a clue where to start from, it's more likely to converge on the "right" local maximum.

So there you go - no more magic.

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