Exponential Innovation and the 64/4 Rule
Financial institutions strive to optimize the benefits from substantial investments they make in innovation. During client conversations about how to get more bang for the buck, I often think about the 64/4 rule. As an insurance executive, I used it for years to enhance return on investment, improve problem solving, and coach employees on the art of innovating smartly.
The 64/4 rule is the less well known sibling of the 80/20 rule, also known as the Pareto principle. They both describe a common pattern involving the uneven distribution of things, especially pertaining to effects and their causes. The Pareto principle was named after an Italian economist who noted a century ago that 80% of the land in his country was owned by just 20% of its citizens. Today, 80/20 has become a rule of thumb for approximating skewed distributions of all kinds of data. It is a useful tool for helping people understand how to improve outcomes by focusing on what matters most.
For example, in many industries, 80% of revenue comes from 20% of customers. Focusing attention on attracting and retaining high-revenue customers is a smart business strategy. In the insurance industry, the 80/20 rule is useful for guiding efforts to mitigate risk. Insurers can be more focused in their loss prevention activities if they identify the 20% of hazards that are driving 80% of accidents. And most software developers know that 80% of application errors are likely caused by 20% of programming defects, so they should search for those frequently used subroutines.
It turns out that you can square the numbers in the 80/20 rule to produce the 64/4 rule. When the 80/20 rule seems to apply to a given distribution of cause-and-effect data, it also tends to hold that 64% of effects (80% x 80%) come from 4% of causes (20% x 20%). Thus, 64% of revenue comes from 4% of customers, 64% of accidents are caused by 4% of hazards, 64% of software errors can be traced to 4% of bugs, and so on.
In guiding innovation investments, the 64/4 rule is highly useful because of how much leverage it produces. Imagine a project proposal that would create a one-time benefit of $1 million and would cost $600,000, producing a net benefit of $400,000. That’s an acceptable 67% return. The 80/20 rule suggests that perhaps $800,000 of benefit could be obtained at a cost of $120,000, producing a net benefit of $680,000, which is an impressive 567% return. But the 64/4 rule would imply that maybe, just maybe, $640,000 in benefits could be obtained at a mere cost of $24,000, which is a stellar 2,567% return.
Do such opportunities exist? Not always, but more often than you might think. Consider a bold project proposal that targets complete automation of 100% of underwriting decisions. For a midsize company, it is conceivable that costs for a full-featured solution would reach a few million dollars for software, third party data, consulting, and internal staff time across the entirety of the project lifecycle. Can we imagine a 64/4 version of the project in which only a 64% straight-through rate was targeted—perhaps by narrowing the focus to relatively simple risks? Can we imagine finding a fast, easy way to achieve that goal—perhaps by leveraging already deployed technologies and being careful to avoid feature bloat—and spending only $120,000 instead of $3 million? I certainly can.
Of course, not all innovation opportunities have a cause-and-effect profile that supports the 64/4 rule. Sometimes, there is an inherently holistic nature about a problem and its solution, making them indivisible into smaller pieces. As Peter Senge famously said, “dividing an elephant in half does not produce two small elephants.” Even then, a philosophy of 64/4 can help. For one thing, it encourages employees to think twice about elephant projects that involve massive cost and risk.
The risk advantage of 64/4 thinking is easy to overlook. When the cost of an initiative is high and the targeted ROI is modest, it is easy to imagine how a cost overrun or lower than expected benefit could result in a huge loss on the project. With a 64/4 scenario, the numbers will likely work out fine even if costs double and benefits are a fraction of expectations. Lowering the risk and magnitude of loss means organizations will feel more comfortable taking chances at the bleeding edge of technology. Modest losses on occasion will be offset by the strategic and organizational value of lessons learned.
The biggest advantage of 64/4 may be the mindset it encourages in everyday thinking. I can think of a couple organizations that even enshrined 64/4 as a corporate value. When we teach employees to believe that for every million-dollar project idea there might be $40,000 alternative, we foster better stewardship of scarce resources. When people think deeply about what would have to be true for a 64/4 option to work, we stimulate more critical thinking, better problem solving, and more creative ideation. That pays off in every case, even on elephant projects.
Today, many financial institutions feel they cannot move quickly enough to respond to the digital disruption of their industries. Creating a 64/4 mindset in which all employees have a bias toward small projects that quickly deliver ROI could loosen the logjam of multi-year project backlogs.
There is much more I could say about the 64/4 rule, not just for business but as a personal philosophy as well. Perhaps I would be forgiven if I wrote a few thousand more words on the subject, but I wish to avoid the irony. After all, 64% of the value of this blog is coming from just 4% of the words.