3 Steps to Turbo Charge Profits
Top financial managers have an opportunity to boost their companies’ profits to new heights. The key to success: become your company’s Chief Profitability Officer.
This may seem like a puzzling suggestion. After all, aren’t CFOs now centrally involved in maximizing profitability? The answer is yes and no.
Certainly, CFOs are the driving force behind developing and monitoring budgets. They relentlessly push their colleagues to increase revenues and reduce costs, and they carefully monitor the financial results, instituting midcourse corrections when needed.
Yet in my research and consultations with leading companies in more than a dozen industries, I’ve found virtually every company is 30 percent to 40 percent unprofitable by any measure, and 20 percent to 30 percent of the business is providing all the reported profits and subsidizing the losses. The potential profit improvement is often 30 percent or more within a year, with comparable improvements year after year.
The underlying problem is that our financial accounting systems aggregate revenues and costs into categories that work well for financial reporting but are not granular enough for effective profitability management. The lack of profitability information results in embedded unprofitability—a critical factor that, amazingly, is unseen, unmeasured, and unaddressed. In virtually every company, even if all managers beat their budget goals, the company still would have a huge profit improvement opportunity.
Moreover, in virtually all companies, the core incentives are misaligned: Top managers are compensated on a P&L basis, while sales reps are paid for revenues or gross profits. Because high gross margin business is often unprofitable on a net margin basis, to put it colloquially, top management’s steering wheel is not attached to the car.
How can a CPO reverse his or her company’s massive embedded unprofitability and generate new streams of profits? Three essential steps: develop a profit map; define priorities and serving models for your important account/product segments; and align compensation throughout your company, especially for the sales force, by basing it on directly on granular profitability.
1. Profit Mapping
A profit map, the core analytical tool of profitability management, displays the profitability and cost structure of every product in every customer in the company. Profit maps show exactly where profit is flowing and where it is lost.
A profit map is not especially difficult to develop, but it is completely different from the information developed for financial reporting. Many finance managers make the mistake of starting with their existing financial information and trying to allocate it into sectors of the business or product families. Instead, the essence of profit mapping is to create and analyze a database composed of the net profitability of every invoice/order line. An experienced manager and analyst can develop a profit map in a month or two.
The process of developing an “income statement” for every order line is relatively straightforward. Your sales file shows the customer, product, revenue, and cost of goods sold. Between each line’s gross margin and net margin is a set of sales costs, operations costs, and overhead costs. For the sales and operations costs, simply develop tables of costs for each cost element. For example, you can identify whether an account is served by a sales rep, by telesales, or simply by your website and assign an appropriate cost for each. Similarly, you can tell by the account location and product type the approximate cost of delivery. Overheads require more judgment.
The value of a profit map is that it quickly highlights your company’s islands of profit and sea of red ink. It also enables you to identify exactly which cost elements are most important in determining profit or loss for specific products in specific accounts. (I call these “profit levers.”) You can translate this picture into an extremely focused “to-do” list for your company?s sales reps. It also provides a powerful basis for aligning the incentives of all of your company’s managers with those of the top management team.
Here’s a critical tip: work at “70 percent accuracy.” Developing a profit map is like writing a paper. Start with a rough profit map using estimates and rules of thumb and then sharpen your pencil only where it will affect a decision. At the end of the process, your company’s operating managers only need to know what one or two things they have to change in each account, what the likely impact will be, and how this will improve their compensation.
Here are a set of questions that profit mapping will enable you to answer.
- Where are we making money?
- Within these profitable customers, how much of their business is unprofitable?
- Is this business safe from competitive encroachment?
- What are we doing to lock in and grow this business (our “sweet spot”)?
- How can we focus our resources on obtaining more of this business?
- What are we doing to increase these customers’ own profitability?
- Which customers are marginally profitable?
- Within these customers, what specific changes would make the biggest improvement?
- Who should make the change?
- How can we set up an ongoing, scalable organizational process that transforms the marginal business into profitability?
- What is the likely gain vs. additional effort?
2. Focus on Priorities
A profit map yields very valuable information. Many managers wonder how to translate this into an action plan. The key is to focus on your priorities and serving models.
Priorities: Most managers instinctively start by trying to improve their marginal and unprofitable customers. This is a big mistake.
The right priorities in order of importance are: securing your most profitable, sweet spot customers (not necessarily your biggest ones); identifying the customers who should be in your sweet spot and focus your sales and operations resources on growing and securing them; identifying ways to turn around your marginal accounts using appropriate profit levers identified in your profit map; and explaining to your unprofitable customers what they need to do for you to continue serving them (often operational coordination rather than price increases).
The first two priorities are critical because the most important thing you can do is to lock in and grow your core of profitable business and cash flow. In most companies, these customers are overpriced and underserved, and smart competitors will aggressively target them. And if you lose these critical customers, it is very difficult to recover.
Serving Models: When you analyze your business, it is helpful to cluster it into customer/product market segments, each of which has similar business and profitability characteristics—and each of which requires an appropriate serving model (set of sales and operations activities). Your profit map will guide you in this process.
Think about a hypothetical company that manufactures products used by a variety of customers. Its large accounts are primarily manufacturers. Its profit map shows the manufacturer accounts are very profitable overall.
However, the profit map also shows a surprising fact: within the large manufacturer accounts, some low gross margin products are very profitable, while many products with high-gross margins are losers. This is concerning because the company’s sales reps are compensated on gross margin and are therefore incented to bring in business that often actually decreases profitability.
Why does this seemingly puzzling situation occur? The profitable products have a very low cost to serve because they are ordered repetitively with long lead times. The unprofitable products lose money because they are expensive and only ordered sporadically, so the supplier has to keep a lot of costly local safety stock.
The upshot is that the manufacturer accounts have two important but different account/product segments. Each segment has a specific profit lever, and each needs an appropriate serving model.
Because the profitable segment has a very low cost to serve, it is reasonable to price low to secure and grow the business. While the unprofitable product segment has a high cost to serve, the profit map implies that if the company gained a few days? visibility into an upcoming order, it could source the product from national inventory, removing the need for costly local safety stock. By focusing the sales reps on this sharply targeted profit lever, the company could convert the unprofitable product segment into strong profitability.
3. Effective Compensation
Compensation is the front-wheel drive that moves your company through the marketplace. In the absence of a profit map, managers have no choice but to compensate sales reps on revenues and/or gross margins. This is not only ineffective, but it actually causes the huge embedded unprofitability in most companies.
Profit maps are the key to reversing this problematic situation. Because they show the net margin of every product in every account, you can compensate your sales reps and other managers on the actual net margin profitability improvement of the elements directly under their control. This will enable you to align your company’s core incentives from top management to grass roots performers.
Chief Profitability Officer
The most critical success factor for a Chief Profitability Officer is to understand that profitability management requires a very different process from day-to-day financial management. Not harder, just different.
By building a program around profit mapping, priorities and serving models, and effective compensation, the CPO can tap into and reverse his or her company’s huge embedded unprofitability—turbocharging profits.
This article originally appeared at http://businessfinancemag.com/article/3-steps-turbo-charge-profits-0929. Copyrighted 2011. Penton Media, Inc.