Uncovering Hidden Profits

Companies sabotage their profitability by measuring the wrong things and managing to the short term, according to V. Rory Jones, cofounder of Business Intelligence Associates and author of The Executive Guide to Boosting Cash Flow and Shareholder Value: The Profit Pool Approach (John Wiley & Sons Inc., 2008). Jones talked with Business Finance about ways to mine hidden cash lodes.

Business Finance: What are profit pools?
V. Rory Jones: They're business areas, and there are two kinds: internal and external. Internally, what they basically describe is the profitability of your business areas, and they do it in a way that's perhaps a little different from the way it's currently reported; it gets down to a distilled profit number that's based in cash for each business area for one current period. So, for example, what's the profitability of this product, what's the profitability of that customer set.

And the other attribute is that it's granular; it gets down to a level that management can actually do something about. You can alter the strategy around that business area -- the products or customer set -- in various ways, and in so doing change the business model and change profitability and performance.

The other type of profit pool is the external view, a more strategic viewpoint that looks out into the market. Probably the best way to think about market profit pools is in terms of the potential for future profitability that they offer. You have to think about the whole market's offering in terms of profit, and about your offering. Given that you're considering strategic moves in the market, which is really what C-suite managers are supposed to be doing, you need a view of that profitability out into the future. Fifteen to 20 years is a good time frame with which to look at market profit pools.

BF: Don't business leaders currently have these views?
VRJ: Not only do they not do a good job of this, they simply don't have access to the information. They rely on GAAP-regulated reporting, and they don't get it down to a granular level within the business. They use a lot of non-cash adjustments in the regs, like depreciation, that completely alter the view of what profitability is.

If you buy, say, a large machine, what the regs require you to do, as everybody knows, is to depreciate that over a number of years. So right at the start, even without getting granular, you've ended up with net income that doesn't include a full charge for what that piece of capital equipment costs.

Clearly non-cash charges are a significant distortion of profitability at the company level. Management needs to get past that, particularly in times such as we're in now when there's an extra scrutiny on cash flow. Management needs to start at the top and clear out all of the non-cash measures and non-cash charges and figure out exactly they're going through.

The second issue is allocation. What management has yet to deal with significantly is to properly allocate charges around the business. If you look at most businesses, they basically rely on "Let's allocate costs based on the revenue proportions that we see" or "Let's allocate costs based on the unit sales that we see." And those allocated costs in no way reflect real resource usage. This is the second major issue that causes a huge distortion in profitability.

BF: So what should a CFO's first move be?
VRJ: If you spend the time to cut through GAAP and figure out profitability at a granular level, you can boost cash flow by tens of percents. You can boost cash flow by a significant percentage of revenues -- 1 percent to 5 percent of revenues -- simply by understanding where the cash drains are and figuring out ways to neutralize them. And then you figure out where the real profit pools are that deliver a lot of excess cash flow so you can redirect your growth capital to those areas.

While it might be painful to figure out cash profitability in detail in three or four key dimensions -- for example, products and services, customers, and geographies -- you can get a tremendous boost that far outweighs the small amount of effort it would take your finance team. And that's without considering long-term issues -- looking outwardly at market profit pools.

BF: Is uncovering market profit pools essentially a question of competitive intelligence?
VRJ: That's a huge component of it. There are several ways of thinking about how to operate in the market. One involves looking at your existing offering, the game you put out there, and it requires an understanding of the competition and the customer.

There is another, greater area where markets don't exist and where you clearly don't yet have a game to offer, where the value-growth opportunity is orders of magnitude greater. If you really want to boost value in your business the only way to do it is to manage to the long term. Think about where you need to be in a 15-year time frame. That, after all, is where two-thirds to three quarters of your business value is, if you're a typical company.

You step back and you look at Amazon and you say how come Amazon is here, despite Barnes and Noble? Clearly because Barnes and Noble didn't take the time to do this rather rudimentary looking forward and figuring out where things are going to go.

You're never going to predict with great accuracy and certainty the first time you do it. You'll get 40 percent or 60 percent there. The second time, you'll get 70 to 80 percent there. If you keep doing this and develop it as a skill, you end up being very good at figuring out where their market is headed -- I've watched this happen over the years at several different businesses -- and you end up being able to manipulate the direction in which the market is going to evolve.