In this 10-minute video, Finding Islands of Profit in a Sea of Red Ink, I discuss the enormous opportunities for profit generation today, the sweeping transformation currently occurring in business, and how managers can succeed in this new era.
Here is the link to the video:
http://www.dcvelocity.com/dcvtv/viewercontributed/1288398437001/
I hope you find it helpful.
A year ago, my new book, Islands of Profit in a Sea of Red Ink, was published. Since then, it was named a best book of 2010 by Inc, and many companies have purchased copies for their top management team. Here are fifteen key questions – with brief answers – that managers have asked me.
Why is 40% of most businesses unprofitable?
All of our management information and processes were developed in a prior business era. Our accounting categories are too broad to see which accounts and products are profitable and which aren’t – so people simply assume that more revenues equals more profits. Some revenues are very profitable, and a surprising portion produce big losses. In virtually all companies, no one is responsible for monitoring and managing the interaction of revenues and costs at the grass-roots level to maximize profits.
How do top managers react to this?
They strongly agree. In years of writing about this in Harvard Business School’s Working Knowledge e-newsletter and website, no one has disagreed. When I speak to top managers about this at MIT and in my consulting clients, no one disagrees. The problem is that they don’t know what to do about it, and they are rightly concerned that just “firing bad customers” (wrong thing to do) will hurt their stock price.
How can this be fixed?
Four building blocks: (1) the right information – granular (specific products in specific customers) not aggregated; (2) the right priorities – first, secure and grow the profitable business, then improve the marginal business, then reprice the money-losers; (3) the right processes – mostly coordinating sales, marketing, and operations to get things right; and (4) the right compensation, especially for sales – matching compensation to real profitability, not just revenues.
Why is your advice particularly important in our current economy?
Today is prime time for rapid improvements. Customers are desperate for new ways to get better, and they’re very receptive to trying new ways of doing things. Most competitors are frozen in the headlights trying to cut costs indiscriminately. The key is to focus on growing the 20-30% of your company that can give you high sustained profitability, and then get more high-potential business that fits. You’ll rarely have this great an opportunity to lock in the best business – just stop wasting good resources on business that will never generate profits.
Why are so many companies today meeting their sales targets but still losing money?
Because budgets are developed and performance is judged relative to history not potential. If a company is 30-40% unprofitable, and its budget aims for a 10% improvement, the company will still have a huge amount of embedded unprofitability. Everyone looks at the improvement and celebrates. But 10% better than last year, and just as good as the competition is simply not good enough.
What are the most common mistakes businesses are making that prevent them from being consistently as profitable as possible?
Three big mistakes: (1) assuming that more revenues means more profits; (2) failing to focus attention and resources on securing and growing the business that produces high sustained profitability – this makes a company vulnerable to focused competitors and reduces reported profits; and (3) failing to put anyone in charge of maximizing account and product profitability at the grassroots level (in contrast with putting lots of people in charge of managing budgets).
What is “the age of precision markets” that we have entered?
In the prior “age of mass markets,” companies sought the economies of scale of mass production, coupled with mass distribution using arm’s length customer relationships. In that era, more revenues really did mean lower costs and more profits. In today’s “age of precision markets,” companies form different relationships with different sets of customers, each with different costs and profits. Yet, virtually all of our management information and processes were developed in the prior era, when all revenues really were equally desirable. This is the underlying reason why almost every company has so much embedded unprofitability and why so many managers fail to see and build their sustainably profitable core of business.
How should the role of the CFO change to adapt to today’s new economic conditions?
In these difficult and uncertain economic times, companies need broad-gauge, strategic CFOs. An effective CFO must be able to chart a course to sustainable profitability and growth, and orchestrate the company’s functional managers to accomplish this objective. This process goes far beyond managing operating efficiencies, cash flows, and budgets. It involves three essential elements: (1) profit mapping – moving beyond our traditional, overly broad, aggregated accounting measures to construct a granular transaction-based picture of account and product profitability; (2) sustainability – identifying the 30-40% of the company that is unprofitable, and more importantly, the 20-30% that is capable of strong sustainable profitability and growth, even in tough times; and (3) driving performance – identifying and prioritizing the key initiatives that will cement and grow the sustainably profitable portion of the business.
Should your advice be adapted differently when we’re in a recession vs. when we start recovering?
The management to-do list is the same, but the distractions are different. In a recession, there is an overwhelming instinct to cut costs across the board and to hoard cash. This is exactly the wrong thing to do. Instead managers should step on the gas – identify and grow the sustainably profitable portion of their business by focusing their resources and investments on these customer relationships. When times improve and all ships rise on the incoming tide, the instinct is to cling to all revenue increases – no matter what the profit impact. Rather, managers should shift their resources to the business that produces high sustainable profits and growth.
How can a company’s sales force become more profit focused?
Four key elements: (1) know the score – both account potential and profitability; (2) know the priorities – secure the best (most profitable) accounts, then get more of the best business, then turn around the marginal business, and lastly reprice the remaining losing business; (3) know the company’s best practice – observe the president’s club winners’ best practices, codify them, and teach them to the others (especially the critical task of ramping up high-potential underpenetrated accounts); and (4) know how to link sales compensation to profitability, not just to revenues and gross margins. Note that these are top management’s responsibility – how can a sales rep maximize profitability if the company’s top managers don’t know how to do it?
How can you make your customers more profitable?
If your operations managers can’t tell you what they would do to maximize a key customer’s profitability, they need to spend much more time in their customers – walking in their customers’ shoes. (Note that I said operations managers, not sales reps.) They need to work directly with their customer counterparts to develop three things: (1) great rapport, relationships, and trust; (2) a joint end-to-end understanding of the activities and costs of the intercompany supply chain – and an agreement on how to lower costs and increase asset productivity for both companies; and (3) an understanding of the political situation and attitudes of the members of the customer’s buying center. These three things will drive huge sales and profit increases, even in highly penetrated customers. Unfortunately, most managers incorrectly assume that operations managers should only meet with customers after a mature sales relationship is established.
How should supply chain management be adapted to be more profitable?
Supply chain managers should have a critical role but are in danger of being bypassed. Traditionally supply chain managers focused primarily on internal cost reduction, an artifact of the age of mass markets. Today, they have to shift focus to supply chain productivity, which involves four critical tasks: (1) understanding and maximizing the earnings of their assets, not just minimizing costs; (2) spending a large portion of their time with their counterparts in key customers (those capable of providing high sustained profitability and growth) in order to figure out how to drive sales by making the customers more profitable; (3) working with the sales and marketing team to develop a standard set of customer relationships (arm’s length to highly integrated), so they can fulfill each in a streamlined and economical way; and (4) teaming with sales and marketing to match customers to relationships.
How should marketing be adapted to be more profitable?
At budget time in many companies, the marketing group gets concerned about quantifying its value-added. Yet marketing is at the center of two critical profitability variables – customer relationships and product development. Customer relationships are the key to securing and growing profitable revenues. Marketing should lead the way in developing a standard set of relationships (from arm’s length to highly integrated), matching customers to relationships, and establishing relationship migration paths to deepen key account integration. The key to effective product development is to meet the needs of the customers in the core of sustainably profitable business, rather than designing products for the average customer. By excelling in these two critical areas, marketing managers can make a huge lasting contribution to profitability.
Does profitability require a different sort of leadership?
Yes, everyone has to manage at the right level. Vice presidents should spend most of their time positioning the company for the next 3-5 years – since that’s the time it takes to develop major new initiatives. Directors (department heads) should spend half their time coordinating with each other to manage the company’s profitability, and the other half directing the managers who report to them. Managers should run the day-to-day company. Instead, in many companies, everyone focuses primarily on the company’s day-to-day performance.
What are the first steps anyone can start taking tomorrow to make their business more consistently profitable in today’s economy?
A small team of managers can analyze the profitability of a multi-billion dollar company at a very granular level in several weeks using standard desktop tools. This is the first step. With this view, the management team can develop a highly targeted set of initiatives to secure and grow the best business, and to turn around the marginal business. Within a year, the company will experience a dramatic, sustainable increase in profitability.
I will be presenting a live webcast, How to Lead a Profitability Turnaround, on Thursday, November 17 at 1 pm EST, offered by Modern Distribution Management. There is no charge for this event.
Here is a link to register for the webcast:
Note that the link also enables you to view the webcast later, at your convenience.
I hope you find it helpful.
When I talk to managers about profit generation, I’m often asked about profit pitfalls – logic traps that lead to major profitability drains. Here are three big offenders:
Each of these questions seems to have a perfectly logical answer that leads to the suggestion that it is OK to carry money-losing business. Maybe, the Sea of Red Ink is not so bad after all.
But think about each question carefully.
Contribution
The question of contribution is one I hear in almost every talk and meeting. After all, the question goes, if our warehouses and trucks are not full, isn’t it better to take some business that helps cover the cost, than to leave them partly empty? Sounds sensible.
There are two big problems with this logic.
First, if a company takes business that doesn’t pay full freight, it also needs a strict “sunset” mechanism to throw out that business (or reprice it) when full-freight business becomes available. In fact, companies almost never do this.
Instead they keep the marginal business because it provides “volume.” When new business moves them beyond capacity, they simply build more capacity. The logic always is that the marginal business provides a contribution. Over time they wind up with a warehouse full of mixed business – some paying its way, some not. This is the source of the Sea of Red Ink.
The second problem is much more insidious. If there is full-freight business available that has not been sold, the company is implicitly letting the sales reps “off the hook” by allowing them to fill their quota with marginal business. The false logic of taking business that covers variable cost but doesn’t pay for full cost removes the pressure on sales reps to do what they need to do: continue to sell until they bring in lucrative business.
The net effect: Islands of Profit in a Sea of Red Ink. And no one knows where it came from.
Product line
The second profit pitfall also seems to have an unassailable logic. Since customers want a supplier with a full product line, it seems obvious that a company has to have some losing products in order to make money on the product line overall.
This seems completely logical. But think about it carefully.
If this logic is true, than the company is essentially making an investment. It is investing in carrying money-losing products in order to generate incremental sales in other products that not only are profitable, but importantly, also cover the losses on the portion of the product line that is underwater.
I can understand this thought process – but it only makes sense if the company calculates the return on this investment, and shows that it is a good investment. How many companies do this?
The counter argument is that it is impossible to do this calculation. However, with a profit map, showing the net profitability of every product in every account – and every account’s buying pattern – you can quickly make this determination. (I explain how to build a profit map in my book, Islands of Profit in a Sea of Red Ink.)
Here is a companion reason why product line logic is a profit pitfall. It assumes that you have to be a full-line supplier. In fact, a quick look around business over the past decade or two shows that many very successful companies like Wal-Mart do very well by positioning themselves selectively in key product categories, and competing on price. It goes without saying that the rock-bottom low prices are generated by streamlining the supply chain and eliminating the extraneous products.
Instead, all too many companies simply assume that they have to provide rapid service for a full product line at prices that are competitive with narrow-line competitors.
There is a way to do this, however. If you keep your steadily-consumed, fast-moving products in local distribution centers, and your other products in consolidated national or regional facilities, you can lower your cost to serve on the slower-moving products so you can carry a full line and make money on all or most of it.
Of course, your customers will have to agree to a slight delay. But here’s the leverage point. You can keep enough local stock of slow moving products for the customers who really are buying a full product line – if you have a profit map that enables you to identify them. For the customers that are cherry-picking you, they either can wait a little, or pay an expediting fee, or broaden their purchases to move into your favored customer category.
This is the power of profit mapping in action.
Traffic drivers
The third profit pitfall, traffic drivers, is very common. Here’s the apparent logic.
Your product strategy centers on attracting customers with a “loss leader” – a product or category that is priced low in order to develop further high-margin sales.
Think about consumer electronics. The new DVDs and CDs hit the shelves on a certain day, and the consumer interest plus attractive pricing generates a lot of business. The retailer may be losing money on this category, but the logic is that the company will make it up in other high-margin purchases.
Almost every supplier has business that looks like this.
When you think carefully about this product strategy, it is similar to the product line logic analyzed in the prior section.
Essentially, the company is making an investment in pricing a traffic driver below full cost in order to generate high-margin sales elsewhere. But how many companies actually track this in order to determine the real return on investment? In practice, very few.
As in the case of the product line profitability, a profit map will quickly show which customers, over time, produce a threshold return on investment on the traffic drivers they consume. Armed with this knowledge, the company can build a smart set of incentives and linkages to move customers to the desired buyer behavior.
Where a customer is simply cherry-picking the traffic driver, the company can develop appropriate measures to minimize the losses.
Profit logic
What these three common profit pitfalls have in common is that each seems so logical.
After all, why shouldn’t you take business that helps pay for the overhead? Why shouldn’t you carry some losing products in order to make money on the whole line? Why shouldn’t you offer some loss leaders, or traffic drivers, to draw in customers who will buy high-margin products?
The truth is that each of these profit pitfalls has a reasonable-sounding logic. The really big issue, however, is determining where the logic produces sound results.
The problem is that in most companies, the policy that follows from the logic is applied indiscriminately, rather than targeted specifically at customers and situations where it makes sense – and not where it doesn’t fit.
The power of profit mapping is that it allows you to draw a line in the sand, and make this precise distinction.
In this way, profit mapping enables you to build your Islands of Profit, while at the same time draining your Sea of Red Ink.
A few months ago, I met with the management team of a medium-sized company having sales problems. The company was in a commodity business, and the sales reps were stuck trying to sell to low-level, price-oriented purchasing personnel in the customers. What could they do?
The answer that I heard: hire rainmakers with C-level contacts. This seemed like a replay of many meetings that I’ve attended over the years.
The real issue is that this common reaction is aimed at a symptom, not the underlying problem. The real problem is not the level of customer contact – it is that the company’s value proposition is not sufficiently innovative and compelling.
The reality is that a rainmaker sales rep with a me-too value proposition will wear out his or her C-level welcome very quickly, while a rep with a compelling value proposition will quickly attract C-level attention.
Extended product
The key to turbocharging your company’s value proposition is to build your extended product. Your extended product is the full range of attributes that a customer experiences when obtaining and using your product. If you are selling office supplies, for example, the extended product includes product information, convenient shopping or delivery, payment terms, instructions, easy return process, strong warrantee terms, and a host of other attributes. In fact the nature of an extended product is so broad, that there is always room for great creativity and improvement.
Think about the smart phone you have in your pocket. The core telecommunications product, phone service, has long been available through your home phone, your office phone, and a dense web of pay phones. But once you have experienced the convenience of having a phone with you all the time, the extended nature of the portability changes your perception of telephone service. Throw in email and other applications, and a new product is born out of an old commodity service.
I remember advising several major telecom companies soon after deregulation, when wireless service was in its youth. I can conjure up a mental picture of a young product manager going before the investment committee of a major telephone company with the proposal to build an extensive new wireless network so adults wouldn’t have to stop at a gas station to make a call, and teenagers could call each other across the middle school courtyard.
The manager would have been laughed out of the room. And then the investment committee would return to its “serious work” of figuring out how to lower costs because traditional telephone service was a commodity under continuous price pressure.
It took a visionary entrepreneur like Steve Jobs to see the possibility and value of an extended telecommunications product. The result: enormous success and hundreds of billions of dollars in company value.
Vendor-managed inventory
I have written several times about my experience working with Baxter to develop one of the first, widely-followed vendor-managed inventory systems. This system, now named ValueLink, is at the heart of much of Cardinal Health’s medical supply business. It represents an innovative extended product that led to enormous value and transformed an industry.
Initially, Baxter was a provider of commodity products like IV solutions. It sold to low-level price-oriented buyers in hospitals, and was subject to constant price wars. Once Baxter dropped its supplies on the hospital receiving dock, its business was completed.
A small work team was commissioned to explore how to break out of this impossible situation. The team decided to simply go exploring and discover what happened after the supplies were received by the hospital. Within a few days, they were stunned by what they found: if the value of a liter of IV solution was a dollar at the receiving dock, the total cost by the time it was administered to a patient was a multiple of that number. And with duplication of activities between Baxter and the hospital, the company had an opportunity to take a multiple of the product cost out of the hospital’s system.
All of a sudden the world changed for Baxter. The company developed the now-familiar system in which it placed in the hospital Baxter operations personnel who counted the hospital’s inventory and transmitted the information to Baxter’s distribution center, where automated systems picked the product into totes destined for patient care areas. These totes were put away by the Baxter personnel on site in the hospital. The upshot was that the hospital’s costs plummeted and service improved to near-perfect levels.
Once the hospital CEOs saw this new system, and experienced the magnitude of the savings, they swung into action. They simply asked Baxter two questions: (1) Can you really do this? and (2) Can we trust you? The answer to both questions was positive, and the result was over 35% sales increases in the highest penetrated accounts in the country.
In comparable situations, I have almost always seen gains of this magnitude. This is the power of creating an innovative extended product – a compelling new value proposition. No rainmaker with CEO contacts needed here.
In fact, when I start working with a new client, one of the first things I do is read the customer service surveys. Buried in most surveys is an innocent-looking question that goes something like this: Which supplier do you trust to help you manage change in your company? If the client is the supplier trusted for change management, the rest is relatively straightforward. If not, we know how to climb that mountain.
Supply chain transformation
About a year ago, I participated on a panel on supply chain transformation along with top officers from P&G, Pepsi, and Chiquita. All three companies were making lots of money and gaining significant market share, even in the depth of the recession, by doing essentially the same thing.
They had identified the customers in their sweet spot – their islands of profit and those that should be in this category – and they were focusing and investing their resources to develop innovative ways to make these customers more profitable on handling and selling the supplier’s products. When the customers made more money on the supplier’s products, they increased the supplier’s market share, and greatly reduced the price pressure.
At the same time, the coordination led to important operational efficiencies for the supplier: better forecasting, smoother order pattern, etc. So the supplier became much more profitable, even as the customer increased its profits and rewarded the supplier with a massive gain in share of wallet. These smart suppliers reinvested a big portion of their new profits in renewing the cycle by finding ever-new ways to expand their value proposition.
This was a real win-win both for the supplier and for the customer. The only losers were the suppliers’ competitors, who were frozen like deer in the headlights trying to cut costs across the board.
Extended products everywhere
Innovative companies in every industry have an opportunity to turbocharge their value proposition by creatively pushing the envelope on developing their extended products.
Take financial services. It would seem that lending money is the ultimate commodity business. After all, money is fungible – which means essentially that you can’t tell one dollar from another. Yet even financial services companies have terrific opportunities to build their value proposition.
For example, one company segmented its customers, and developed highly streamlined processes and customized information for its sweet spot customers. At the same time, it drew on its vast local experience and contacts to help these target customers grow and succeed, and it committed to support them in good times and bad. This was a very compelling value proposition, which converted its commodity business into a highly differentiated one.
Developing your value proposition
What does it take to develop your value proposition? An open mind, clear vision, and a little legwork.
The Baxter innovation began as a “showcase” project. Baxter simply contacted a friendly hospital and asked if it could send in a small team to look around. The objective was to try to find new ways to improve customer service and lower costs. The team – and the hospital – didn’t know what it would find, but both thought it was a good idea to take a look.
Once in a customer, it is very important to look with an open mind at what the customer actually does and experiences through the entire cycle from discovering a need to consuming the product (and even needs that arise after consumption). The objective is to “walk in the customer’s moccasins,” and the best technique is simply to spend a lot of time observing individuals as they go about the process. Questions can come later.
Here’s another powerful technique: go on a journey of exploration. For example, several years ago, GE’s Canadian appliance division asked its VP of Manufacturing to explore what innovations other companies had developed that were not necessarily well-known. After significant research and field work, he discovered an incredibly effective process for make-to-order manufacturing that a small company in New Zealand had developed. (I describe this system in Chapter 24 of my book, Islands of Profit in a Sea of Red Ink.)
When he visited the company, he was amazed by the creativity and innovativeness of the process. He took the knowledge back to Canada, reorganized the company’s manufacturing process, and produced stunning results. The process was soon implemented in GE’s appliance manufacturing facilities around the world, and now – like vendor-managed inventory and make-to-order manufacturing – is a standard way for leading companies to do business.
Pushing the envelope
Every company has an opportunity to turbocharge its value proposition. The rewards are tremendous: strong competitive differentiation, surging profits, and expanding market share – even in a commodity business. No, especially in a commodity business.
What’s preventing top managers from pushing the envelope on value creation? In most cases, it is the strong human tendency to simply assume the status quo and focus on tuning it up.
Turbocharging your company’s value proposition costs nothing and takes little time. All you need is an open mind, clear vision, and a commitment to do things better.
Today’s market leaders all are constantly, almost frantically, trying to push the envelope on their value proposition. That is how they became market leaders, and that is why they stay that way.
Why not decide to do the same? After all, that’s all it really takes.
Have you ever wondered why we hiccup?
I recently reread a fascinating book, Your Inner Fish, written by Neil Shubin, a professor of anatomy at the University of Chicago. In this very readable book, he describes how we humans carry the very real vestiges of our evolutionary past – hidden right in front of our eyes – in the way our bodies work every day.
For example, hiccups. Shubin writes, “If the odd course of our nerves is a product of our fishy past, the hiccup itself is likely the product of our history as amphibians… It turns out that the pattern generator [nerve controller] responsible for hiccups is virtually identical to one in amphibians. And not in just any amphibians – in tadpoles, which use both lungs and gills to breathe.”
Shubin continues, “Tadpoles use this pattern generator when they breathe with gills. In this circumstance, they want to pump water into their mouth and throat and across the gills, but they do not want it to enter their lungs. To prevent it from doing so, they close the glottis, the flap that closes off the breathing tube…. They can breathe with their gills thanks to an extended form of hiccup.”
In short, our hiccups are a vestige of our evolutionary past – when we shared an ancestor with tadpoles.
In another terrific book, The Accidental Mind, David Linden describes the evolution of the human brain, and shows how “the brain is not an optimized, general purpose problem-solving machine, but rather a weird agglomeration of ad-hoc solutions that have been piled on through millions of years of evolutionary history.”
What does this have to do with business?
Your company’s evolutionary past
It has everything to do with business.
If you really want to understand why a company does what it does, just look at its business challenges and situation five to ten, or more, years ago. Chances are that most of what the company does simply grew out of the way it met past needs, and that these business practices were passed along as part of the company’s culture – “the way we do business” – over the years, without being reviewed and reconstructed.
I teach a very powerful case about this in my graduate course at MIT. This case presents a very complex optimization problem. Typically the students work hard on the optimization and come to class prepared to discuss their quantitative approaches. I surprise them by starting the class discussion by asking “What is the problem we need to solve?”
After a lengthy discussion, it turns out that the company no longer needed the process that was being optimized. The more complex the optimization, the less likely the students would be to think about whether the underlying process was actually needed.
The prime lesson of the class: the most important things a company does are determined tacitly, and are never seen, never questioned, and never examined. Within this tacit, historically-determined framework, a lot of tuning up takes place, but the framework itself – “the way we do business” – is almost never examined.
What’s most important is that the really big money lies in changing the tacit framework, not in tuning it up. But almost no one operates at this more fundamental level.
In fact, a prime objective of my course is to sensitize students to this enormous opportunity in every company, and to teach them to identify the really big benefits that come from operating at a deep level of understanding. My companion objective is to teach them how to manage the paradigmatic change that is needed to transform a company’s fundamental way of doing business.
What Margaret Mead said
To emphasize the point about the pervasive unseen influence of the past, I tell the class a Margaret Mead story. When I was a student at Columbia, I took an anthropology course offered by the famous anthropologist, Margaret Mead, in the last year she taught. The course was about how culture was transmitted through the generations. We studied a variety of interesting situations, from Pacific Islanders to Morris Dancers.
Toward the end of the course, a student raised his hand and asked whether Americans had any traditions that were passed unseen through the generations. When Professor Mead asked what we thought, she heard responses like “hot dogs” and “baseball.”
She then gazed out at the lecture hall with about 500 students in attendance. She asked everyone who was born and brought up in New England to raise his or her hand. I was brought up in Western Massachusetts and Connecticut, so I raised my hand. I looked around and we New Englanders were ringed around the sides and back of the room like a horseshoe.
Why did this happen? She explained that in the early days of town meeting government in small New England towns, the selectmen asked for volunteers to do the town’s work. If there weren’t enough volunteers, the people who sat in the front and middle were called upon to help.
So over the years, New Englanders started to sit on the sides and back of the room – and this tacit behavior was passed down through the generations without anyone realizing why, even long after people stopped going to town meetings.
The problem with zero-based budgeting
Several years ago, zero-based budgeting was very popular with managers. Its logic, on its face, is very sensible: all expenditures should be evaluated as if there were no pre-existing practices. I think of this as the “if I could only wave a magic wand” approach to business.
The problem with this seemingly obvious approach is that it is almost impossible for managers to penetrate below the surface business procedures to examine and question the more fundamental “way we do business.” Managers almost always get so stuck in their traditional way of doing things that they become unable to carry out the objectives of zero-based budgeting. Hence, they fall back on tuning up existing practices for small incremental gains.
Breaking the mold
How then can a manager see more clearly his or her company’s tacit set of business practices, in order to take a real zero-based look at the company?
The answer is a technique that I call profit mapping, which gives a crystal clear picture of the company at a very granular level. A profit map shows the profitability of every product in every customer, and identifies where re-thinking and resetting a company’s “way of doing business” is most needed.
Every company is an “accidental company” in the sense that it is built to a surprising extent from old business practices. In my consulting and research, I’ve found in industry after industry that even in leading companies, 30-40% of the business is unprofitable by any measure, while 20-30% provides all the reported profits and subsidizes the losses.
Why does this occur in so many companies?
Because in our prior Age of Mass Markets, profitability was a function primarily of sales volume, which created economies of scale in everything from production to distribution to advertising. Prices were set by manufacturers, and distribution costs were very homogeneous because products were simply delivered to the customers’ receiving docks.
In the past 30 years, we have moved into what I call the Age of Precision Markets, in which everything changed. Prices are negotiated, and often vary by account and product. Costs also vary widely, as suppliers form very different relationships – ranging from arm’s length to highly integrated – with their customers.
At the same time, the traditional broad accounting categories of revenues and costs, which worked so well in the prior era and which work well for financial reporting, are completely inadequate for understanding granular profitability today. Yet we continue to manage as if we still live in the prior era.
What you get is the familiar pattern of “islands of profit in a sea of red ink,” that is the vestige of doing business in a way that worked years ago, but no longer fits. Just like hiccups and sitting on the sides of an auditorium.
Profit mapping
The power of profit mapping is that it yields an extremely powerful view of the company as it really is today – where it is working, where it is not, and why.
I describe profit mapping in detail in my recent book, Islands of Profit in a Sea of Red Ink. In essence you create a set of cost tables, and develop an “income statement” for every invoice line. Because you can identify the invoice line’s account, product, sales rep, and other factors, you can develop a very powerful database that shows the profitability of every product in every account.
When you see this very granular picture of your company’s profit landscape, you will immediately realize where your company’s activities – its “way of doing business” – fit today’s business needs, and where they are deficient because they are essentially continuing to apply old ways of doing business that are vestiges of the past and no longer appropriate.
With this detailed profit picture, you almost can’t help but take a real zero-based look at your company. Of course, you can’t just flash-cut to a new way of doing business. But you will be able to develop a sound step-by-step plan to bring your “way of doing business” into alignment with today’s business needs.
And this is where the really big money is. How big? The upside is often a profit improvement of 30% or more year after year. All self-funded by the cash flow you will generate. The best of all worlds.
New profitability
What’s the timeframe for profit mapping? In a few months a small team can analyze a company and develop quantum profit improvements.
And because these actions are rooted in an intuitively clear, granular profit picture, you can be confident that they will work.
Without a hiccup.
Have you ever had an experience at a meeting that you will never forget? Here’s one of mine.
A few years ago, I was advising a major company in restructuring its supply chain and customer relations. I visited one of the company’s most important suppliers. This supplier was very well run, with a well-regarded sales and operations planning process. In the course of our frank and confidential discussion, a senior VP of the supplier leaned over and said to me, “We always forecast their forecasts.”
The supplier executive was referring to the difficulty of forecasting sales. In fact, my client was quite well run, and had state of the art forecasting and replenishment systems. Nevertheless, the forecasts were often inaccurate, and the supplier simply formed its own judgment about the customer’s upcoming purchases.
Why is forecasting so difficult in so many companies? I thought about this question a few days ago as I prepared for an interview with a writer penning an article on forecasting branch sales and expenses.
Traditional approaches
The traditional approach to forecasting is to analyze historical trends, and project them into the future, often by product or product line. Of course, this assumes that the future is like the past. It also implicitly assumes that the company does not have the ability to dramatically change sales. In a rapidly changing world, this approach leaves much to be desired.
A second approach is to correlate sales with a broad economic or industry indicator, such as an industry purchasing or inventory index. The difficulty here is that, even if you understand the correlation and relevant time lags, you still have to forecast the indicator.
Here’s a third traditional approach. In many companies, the sales forecast is a compilation of each sales rep’s individual forecast. How does a sales rep forecast sales? For a start, each rep has a sales quota for the upcoming year, and it’s always larger than the previous year’s – even in a declining economy. Think about this: have you ever seen a sales rep forecast sales below his or her quota?
The underlying problem
The underlying problem with the first two traditional forecasting approaches is that they are too aggregated and passive to be consistently accurate. In fact, a company’s overall sales is a blend of a set of identifiable revenue streams – difficult to forecast in aggregate, but individually much more amenable to accurate prediction. Importantly, you need a different predictive technique for each major revenue stream. These can be summed into a very precise forecast.
The problem with the third approach, of course, is that not all sales reps meet their quota – often leading management to develop a “secret forecast” using the first two approaches. This is a real problem in a declining economy.
A precise approach
The starting point for precision forecasting is to disaggregate a company’s revenues into a set of major revenue streams, each of which has similar characteristics. Here’s an old Byrnes family recipe.
Divide your company’s accounts into core and non-core categories. Core accounts are major accounts where you have a strong relationship and ongoing sales, where you are a dominant supplier. Non-core accounts are lower-volume accounts that either purchase steadily or occasionally. Core products are products that have high aggregate sales volumes, while non-core products are slower movers.
You can display this categorization in a simple 2 x 2 matrix, like the one below.
Core products in core accounts. This is a critical part of your business. It represents your most important, high volume products in your most important customers. Note that there will be a relatively small number of products and customers in this category.
Here, there are two key elements to a good forecast.
First, it is critical to have ongoing intensive discussions and collaboration with these customers, especially with the customer’s sales and marketing team, so that you develop a deep understanding of the factors that are driving their sales and purchases of your products. Often, you will have as much knowledge as the customer has, and surprisingly often the customer’s replenishment and purchasing team does not have a close relationship with their sales and marketing counterparts, or even a deep understanding of the complexities of their business.
Because there are relatively few key products and customers, this is not an onerous task. Besides, you will develop a very productive set of relationships throughout the customer’s buying center that naturally drive higher sales along with operating cost reductions.
Second, new and lost business reports make all the difference here. Many companies require their sales reps to file reports outlining new and lost accounts. Because sales reps are busy and have many accounts, they often neglect this. By focusing the process on core products in core accounts, and tracking this carefully, you can make the reports pragmatic and effective. This is one of the most critical elements in precision forecasting.
Non-core products in core accounts. Once you have developed a strong understanding of the core products in your core accounts, this knowledge will strongly inform your forecast of their non-core purchases. In the course of your discussions with these major customers, you can find out the big changes they envision, and develop a sense of how these will affect the lower-volume products they purchase.
For example, you might learn that the customer is phasing out a product line, or going after a new set of accounts. Both would have an impact on your sale of non-core products to the customer. Note that this important information would not emerge in an aggregate forecast.
Core products in non-core accounts. This category has two major components.
First, many non-core customers are simply small businesses that do not have a lot of purchase volume, or they may even be larger companies that do not make large purchases in your category. Here, the first two traditional forecasting approaches are adequate.
Second, some non-core customers are really very important, high-potential underpenetrated accounts. This is a critical group because this is where a great sales rep can obtain rapid major sales increases. In fact, in my research and consulting, I’ve found that the top-performing President’s Club winning sales reps in company after company are experts at turning around high-potential underpenetrated accounts.
The key to success in this group is to distill your company’s best practice from your President’s Club winners and teach it to your average performing reps. When your average performers develop account plans to turn around and grow their high-potential underpenetrated accounts, you can simply use the account plans as the basis for forecasting this group. Of course, not all reps will meet their account plans, but with a little experience, you can develop a very good forecast of expected sales of important core products to this group.
Non-core products in non-core accounts. This category is comprised of slow moving products bought both by small businesses, and by high-potential underpenetrated accounts. Here, it makes sense to use the first two traditional forecasting approaches. Because the high-potential underpenetrated accounts are in growth mode, their purchases of non-core products probably will be relatively minor.
Forecasting paradigm shift
Precision forecasting involves a paradigm shift in your fundamental approach. Traditional forecasting is largely based on historical, aggregated, passive information.
Precision forecasting, in contrast, involves disaggregating your revenues into critical components, and forecasting each component appropriately. It also involves inserting a major element of control – both intensive discussions and collaboration with major customers, and purposeful penetration of high-potential underpenetrated accounts.
This new paradigm gives you both much better forecasts, and much better account and sales performance. What could be better than controlling your own destiny?
One of the biggest problems in effective profitability management is the instinctive desire on the part of many CFOs for too much accuracy. How can this be?
In my experience, there is good accuracy and bad accuracy. Let me explain.
Good Accuracy
Accuracy is essential for financial reporting, a prime CFO job.
I’m on the Audit Committee of a NYSE company, and we spend a lot of time making sure that the company’s financial results are reported extremely accurately. Like all public companies, we have controls and audits to ensure that even inadvertent errors are uncovered and rectified. The SEC and other regulatory bodies take strong measures to enforce this requirement.
This need for strict accuracy in financial reporting shapes the culture of all Finance Departments. Most CFOs and other top finance managers have strong accounting backgrounds, and many have managed internal auditing departments.
This strong cultural bias causes two big problems in profitability management: (1) the overly rigid use of financial reporting information for granular profitability analysis, precisely because it is so accurate; and (2) an unfortunate insistence on a very high degree of accuracy in profitability management. Both get in the way of effectiveness.
Bad Accuracy
The first problem, using financial information for granular profitability management, seems counterintuitive. After all, great financial information is available and the company has worked hard to ensure its accuracy – why not use it?
The problem with simply using existing financial information is that it is compiled into categories that are much too broad for effectively managing profitability. Here’s the acid test: if you select five accounts at random, and select five products at random in each of those accounts, would you know (or could you find out quickly) the profitability of each product in each account? In virtually all companies, the answer would be no.
This leads to the problematic situation of virtually all companies: 30-40% of the business is unprofitable by any measure, and 20-30% provides all the reported profits and subsidizes the losses. This results in a huge amount of embedded unprofitability in virtually every company – unmeasured, unseen, and untapped.
Why does this occur? Because revenues and costs are compiled into categories that work well for reporting the company’s overall financial results, but are not granular enough to match revenues and costs on an invoice line basis. As a result, finance managers embark on a problematic exercise in allocating these accurately measured costs and revenues into broad categories of account segments and product families – usually by using imprecise allocation functions.
All too often this becomes an exercise in trying to measure accurately things that can’t be accurately measured. The objective implicitly becomes measurement itself, rather than clearly and relentlessly focusing the organization on discovering and acting on the most important profit opportunities.
Instead, you need a completely different process to develop effective granular profitability information. I call this process profit mapping. It involves essentially developing a 70% accurate “income statement” on every invoice line, then putting these into a database and sorting them by product, account, and other essential dimensions. I describe how to do profit mapping, and provide a number of concrete examples, in my book, Islands of Profit in a Sea of Red Ink.
The process takes an insightful manager and analyst about a month or two, using standard desktop tools.
It is critical to understand the important difference between information developed for financial reporting and information developed for management control. This is one of the basic distinctions drawn in introductory accounting and finance courses, yet it is deceptively easy to blend these together when the finance managers have already developed a huge amount of very accurate financial reporting information.
What is 70% accuracy?
Many top financial managers, particularly CFOs, have difficulty understanding the need to work with 70% accurate information for profitability management. They are so culturally accustomed to producing extremely accurate financial reporting information, that they tend to view 70% accurate information as merely the result of inadequately careful work.
Nothing could be further from the truth.
In order to understand the needed degree of accuracy for granular profitability management information (as opposed to accurate financial reporting profit information), you have to start by thinking carefully about what managers throughout the company will do with the information. Then you work back to the nature of the information that will be most helpful to them.
The first set of actions that managers will take with a set of granular profitability information is to quickly see where the business is making money, where it is losing it, and why – its islands of profit and sea of red ink.
In practice, most companies have perhaps 10-20 clusters of product/account segments, each with its own internally similar characteristics and profitability – but each very different from the others. These will be very obvious in your profit map, even with 70% accurate information.
The action question for each product/account segment is: what one or two things can you do that will have the biggest impact on profitability: Is it pricing? Order pattern? Product portfolio? Visibility into big orders, etc? I call these profit levers, and the big payoff comes from finding the smallest number of actions that produce the biggest results.
The most effective way to manage this process is to start with a rough profit map, using readily available information and estimates. The outlines, composition, and profit profiles of the product/account segments will literally jump off the page. By examining a few typical accounts in each segment, you will quickly see the most effective profit levers. But remember that these almost always are different for each segment.
At this point, it is helpful to sharpen your pencil where the additional accuracy will make a real difference: measuring the exact problem that the profit lever will fix, and developing a precise program to remedy it. This requires a higher degree of accuracy in order to specify highly focused initiatives in your target areas.
This process will enable you to match your degree of accuracy with the likely use of the information. Where better information is clearly not needed for a high-priority action, why spend valuable time and bandwidth on developing it? Instead, find out early where enhanced accuracy will really make a difference, and focus your time and resources where they will produce the biggest payoff.
Maximum profit impact
The more subtle problem with bad accuracy is that profitability management is a moving target. Companies change all the time, especially in a complex economic situation.
Even more importantly, when your managers have worked with an initial set of profit levers to produce radically improved profits, a new set of opportunities for profit generation will naturally arise.
This means that your profit map, along with your segment and profit lever identification, must be very dynamic. If you make extremely accurate measurement the implicit objective, it is very hard to move as quickly as necessary in order to maximize your profitability.
Another critical problem arises. When you focus on measuring everything extremely accurately (implicitly believing that everything is important enough to warrant it), you are in danger of flooding your managers and sales reps with so much information that they will not be able to act effectively. They will lose the critical understanding of the smallest number of realistic actions that will produce the most powerful set of results.
Instead, by aligning your information accuracy with the nature of the information use, you will have the biggest impact on your company’s profitability. And for all CFOs and other top finance managers, maximum profit impact is the ultimate management objective.
