Improving Profitability from a Granular Level

The best way to boost your company's profits is to 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 – relentlessly pushing their colleagues to increase revenues and reduce costs, carefully monitoring the financial results and instituting mid-course 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 30-40 percent unprofitable by any measure, and 20-30 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.

Why is this happening? Because in virtually all companies, no one is directly responsible for managing profitability at an appropriately granular level – matching of revenues and costs on an order/invoice line basis.

Think about this: If you selected five of your accounts at random, then selected five products in each account, could you tell if those 25 account/product situations were profitable on a net margin basis? In most companies, the answer would be no.

The underlying problem is 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. This results in a huge amount of embedded unprofitability – which amazingly is unseen, unmeasured and unaddressed.

Moreover, virtually all companies' core incentives are misaligned: top managers are compensated on P&L while sales reps are paid for revenues or gross profits, even though high gross margin business is often actually unprofitable.

How can a Chief Profitability Officer reverse this massive embedded unprofitability, generating huge new streams of profits? Three essential steps: (1) develop a profit map; (2) define priorities and serving models for your important account/product segments; and (3) align compensation throughout your company, especially for the sales force, by basing it directly on granular profitability.

Step One: 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. (I describe in detail how to construct and analyze a profit map in my book, “Islands of Profit in a Sea of Red Ink.”)

A profit map is not especially difficult to develop, but it is completely different from the information developed for financial reporting.

Step Two: Priorities and serving models

A profit map yields a huge amount of 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 mistakenly start by trying to improve their marginal and unprofitable customers.

The right priorities in order of importance are: (1) secure your most profitable, sweet spot customers (not necessarily your biggest ones); (2) identify the customers who should be in your sweet spot and focus your sales and operations resources on growing and securing them; (3) identify ways to turn around your marginal accounts using appropriate profit levers identified in your profit map; and (4) explain 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 and your best customers often are overpriced and underserved.

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.

With this understanding, you can identify the most effective profit lever (cost or revenue element you can change) for each customer/product segment and build the right serving model for each segment. This powerful process enables you to create and manage a profitability turnaround that is highly focused, extremely fast and nearly cost-free.

Step Three: Effective compensation

In the absence of a profit map, managers have no choice but to compensate sales reps on revenues and/or gross margins even though this may actually decrease profits.

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.

Chief Profitability Officer

The most critical success factor for a Chief Profitability Officer is to understand profitability management requires a very different process from day-to-day financial management. Not more difficult, just very different.

By building a program around the three critical elements: profit mapping, priorities and serving models and effective compensation, the Chief Profitability Officer can tap into and reverse his or her company's huge embedded unprofitability – turbocharging profits in three steps.

Jonathan Byrnes, a consultant and senior lecturer at MIT, is a frequent contributor to Business Finance. His latest book is Islands of Profit in a Sea of Red Ink.