Having an effective profitability management approach to running a business can be an important differentiator of performance. So who's responsible for profitability management in your company?
While executives and managers have profit targets, few companies have a process for systematically managing profitability on a daily basis using a consistent analytical framework -- a way to reliably achieve wider margins. The finance organization is best positioned to take the lead role in this function because it has no vested interest in revenue-generating or cost-producing activities and because its staff typically has a deeper bench of the people with analytical skills who are crucial for success.
Some clarification is needed here. The term "profitability management" is a bit problematic because companies have multiple ways of managing profitability and so the words mean different things to different people. To be sure, most companies attempt to maximize their revenues and minimize costs, both of which are ways of achieving profit objectives. Yet these alone do not constitute profitability management because realizing them does not necessarily enable a company to achieve maximum profitability or optimize profits in concert with its strategic objectives.
Profitability management involves employing one or more techniques for optimizing (not just maximizing) returns to meet strategic objectives. For example, in some cases, the right approach to achieving a company's long-term strategy might involve sacrificing short-term margins for increasing volume for certain businesses or products. Or it may take the form of a customer profitability initiative that unbundles services and other extras from an offer and charges all but the best customers for these add-on items.
It could mean adopting activity-based costing (ABC) or some other marginal-cost approach to determining the economic cost (not the standard accounting cost) of a good or service. It might involve adopting a completely new tactic such as pricing optimization, which attempts to extract higher prices from those willing to pay more (examples include airline tickets and interest rates on loans).
Doing a better job of managing profitability is not a new concern. Companies began to re-examine product profitability in the 1980s, applying marginal cost analysis techniques because it had become clear that traditional cost accounting methods do not provide a useful gauge of their true economic profitability. In the United States, ABC was widely promoted, but efforts usually foundered on the complexity of the techniques used. Simplified approaches have developed since then that require far less effort to establish and maintain.
Companies also need to know how profitable their customers are. This allows them to identify where hidden (or ignored) costs associated with serving customers can reduce overall profitability. Financial services companies have been trying to measure customer profitability for two decades because they recognize a wide disparity between the most and least profitable customers. Indeed, for years research has shown that financial services companies make high profits on only a small percentage of their best customers and lose money on a much larger number of them.
Airline deregulation and the rise of low-cost carriers in the early 1980s forced established carriers to develop sophisticated pricing models to remain competitive. This same technique is used in other industries such as consumer lending.
Software is a key component of any profitability management initiative. There are analytical tools that can do economic cost analysis, identify optimal pricing and determine the best approaches to achieving strategic objectives. There are decision support tools that provide guidance to individuals in setting prices, terms and conditions. And there are reporting tools -- dashboards and scorecards -- that provide essential feedback.
Companies must develop a focused, consistent approach to managing profitability that incorporates four essential elements: strategy, analytics, information technology and people. This must be done at a corporate or unified business unit level instead of in departmental silos because the objective is to balance the trade-offs required of functional groups.
Information technology is a key component in the success of profitability optimization initiatives because it gives executives and managers important insights into what drives real (not just accounting) costs and provides analytics that will enable them to quickly determine the best ways to optimize trade-offs.
Today's systems are fast and flexible enough that pricing, production and even incentive compensation decisions can be made frequently. Done properly, such a comprehensive approach to profitability can produce the outcomes the business seeks.
Ventana Research Profitability Table
