I was talking with someone last week who was asking me about how she could improve her cash flow each month.
And, in fairness to her, she has a good handle on where her money is going. A couple of months ago she decided to see if she could save cash by reducing what she was spending on various things, along with trying to get better value for the cost of utilities etc.
What she was frustrated by was that for an awful lot of effort on her part, the savings weren’t that big and she wondered was it worth the effort at all or was she doing something wrong?
After all her phone calling, changing some providers, spending less, she managed to reduce her monthly outgoings, she told me, by €65.
And what she said got me thinking about The Pareto Principle, commonly known as the 80/20 rule.
For those of you who don’t know what it is, let me briefly explain: It was named after an Italian economist who noted that 80% of his country was owned by just 20% of the population.
This principle was later adapted in the 1940s by a guy called Joseph M. Juran, who said that 20% of a person’s efforts, in whatever it is they do, will result in 80% of their returns. And of course it follows on that the other 80% of your efforts result in 20% of your returns.
Mr Jurin said that if you focus on the 20% of your efforts that give you the biggest return, you would be better off and you would eliminate a lot of time, effort and energy in the process.
The Pareto Principle over the years has been applied to many things - in business for example it can be shown that 80% of sales come from 20% of customers; 20% of products produce 80% of sales; 20% of staff will cause 80% of problems.
In our own lives, it can be applied as well and the one that I like best and might resonate with people is that 20% of the clothes we have in our wardrobe are worn 80% of the time
Anyway, back to the person I was telling you about, who wanted to improve her monthly cash flow.
I began to wonder was she focusing too much of her efforts (80%) on the things that would only give her a small return (20%)?
I wanted to find out if she was so I asked her to give me a breakdown of what she was spending her money on each month and what were the areas she focused on that she thought would save her money?
When she did, I broke down her outgoings into different categories and applied what percentage each of them was against her gross annual income. The combined income of herself and her husband was €80,000.
Some of my observations of where her income was going each month were as follows:
n 25% of their biggest outgoings comprised taxes – €19,730 of their salary was going towards income tax/prsi/USC
n 25% was going towards housing costs i.e. mortgage payment/life assurance payments/food (€1,667 per month)
n 7% towards loan repayments (€466 pm)
n 10% towards transportation/work related costs (€667 pm)
n 6% towards utilities i.e. electricity/phone/TV/broadband and I grouped home and car insurance in with this category as well (€400 pm)
If she wants to improve her cash flow each month and we apply the Pareto Principle to her finances and focused on a couple of categories in particular, she will get a much better result (80%) with less effort (20%)
And the reason for this is simple. If, for example, they can cut €100 per month from their annual tax bill of €19,730 then all they need to reduce it by is 6% as opposed to trying to take 25% off their utility bills costs which is unrealistic anyway, if they wanted to reduce it by the same €100.
Tax bill = €19,730 reduce by 6% = €1,200 saving
Utility bill = €4,800 reduce by 25% = €1,200 saving.
But can they reduce their tax bill by that amount? Absolutely they could. They are taxed as individuals at the moment and if they became a dual income couple, the amount taxed at 20% is €42,800 plus the lower of €24,800 or their spouse’s income.
Therefore by being jointly assessed for income tax purposes they can earn up to €67,600 at the lower rate of tax.
What this means to them is that their net take home pay is going to go up by €761 per year or €63 each month.
Here’s another thing they did to reduce their tax bill: her medical insurance is paid by her employer who charges her benefit in kind on the premium they pay on her behalf. She can make a claim and receive a 20% tax credit on the premium up to a maximum of €1,000 i.e. €200. She didn’t know she could do this.
So, focusing on just one area she was able to reduce her annual outgoings by just under €1,000 with very little effort.
She was able to achieve a lot more with a lot less effort than the €65 she saved on a number of small items that took a whole lot of effort.
Of course she is right to focus on other areas of her finances where she can reduce her expenses – I suspect if she brought her lunch to work every other week instead of buying it every day, car pooled and so on that she would reduce her outgoings further.
The idea of the Pareto Principle is for you to look at all of your outgoings and identify which are the big ticket items that are taking up the biggest percentage of your income and how being smart and being able to reduce them by a small amount relative to their overall cost is the same as having to get a much bigger impact from areas that aren’t costing you as much.