5 Approaches to Profitability
With the economy slowing, many companies will shift their focus to improving their profitability. Is your management team prepared to take a fresh look at how to grow profit margins? In our work with mid-market companies over the last decade, we have helped uncover many different ways to improve profits. Here are our Top 5 approaches to improving your profitability, with two bonus tips for good measure.
1) Do you really understand the economics of your business?
It’s vital that the right metrics are used to measure profitability. An example: when working with one client that sold direct to customers and also sold through distributors, we realized the way our client defined their profit margin led to an incorrect view of the economics of direct vs distributor customers. Because this client defined profit margin from net revenue (after large customer discounts) instead of gross revenue, the discounts didn’t factor into the calculation—so this client fooled themselves into believing that the customers who purchased through the distributor were more profitable than they really were. Defining financial metrics so that they are meaningful and lead to good business decisions is critical for making decisions that can improve the bottom line.
Realizing the true economics of a business—by using the correct, properly defined metrics—thoroughly changed this client’s understanding of what a “good customer” looks like and, in turn, helped maximize profits going forward. In effect, this client doubled sales when they shifted their focus to selling direct when possible.
This particular client’s experience shows how vital it is to have a clear understanding of each individual component of the bottom line. Without a clear view of each component, it’s difficult to make decisions on how to move forward.
2) When was the last time you reviewed the structure of your pricing?
Be sure to review and refine your pricing strategies every couple of years. Not regularly refreshing your view of pricing leads to not charging appropriately. What happens all too often is that a particular situation leads to offering a price adjustment, then that adjustment becomes the norm. This results in a pattern of not looking at all customers in the same way and then offering customers discounts that are not warranted.
It’s smart to look at customers in aggregate, not in a vacuum. Take a step back to understand the context of why some customers enjoy a certain price and realize that sometimes prices are determined by unique, one-time circumstances that morph into habit. A discount doesn’t have to—and shouldn’t—apply to every customer.
Equally important is to maintain discipline in raising prices. The longer clients become accustomed to not experiencing price increases, the harder it is to raise prices when necessary. Raising prices regularly means that clients come to expect it as a natural course of business. Training customers to expect a price increase every year—even if it’s a nominal increase—makes the event ordinary and minimizes scrutiny.
3) Why is my profit margin not improving as I grow?
One of the great myths in business is that overhead costs are largely fixed and, therefore, as a business grows the bottom line improves on its own. The reality is that this doesn’t happen on its own. As companies grow, more resources are required and everything gets more complex. Ideally, systems are periodically redesigned to handle higher volumes. In reality, all too often companies will simply throw more bodies at the problem. The final result is that instead of overheads scaling with revenue, overheads grow at the same rate as revenue and the bottom-line margins stay the same.
Bottom line margin does not naturally grow as the company grows, but it can be “managed” to grow. Growth gives companies the opportunity to be more efficient. New processes, systems and organizational structures can all lead to greater efficiency and are easier to accomplish the larger you are. The key is to plan and budget for scale. If you plan to double the business in the next five years, set the goal now that each overhead department has a plan for how to accommodate double the volume at less than double its current cost. What processes would need to be redesigned? What new software would be required? How would the organizational structure look at double the volume? Being proactive and putting in the extra effort to use the right system will give your team the breathing space and time necessary to keep pace with growth.
An example of this might be a company’s accounts receivable department. The easy answer is to add personnel to a department to handle the extra work that is inherent with a higher volume of business. But once a company reaches a certain size, it may make more sense to utilize automated software—and to save the money of adding more staff to your team. Another example is often evident in the sales department. As the business increases, are more sales people necessary, or can you reorganize territories or automate processes to make the salesforce you have more efficient?
4) Does this activity still add value?
Every couple of years every company must ask this question: does doing this activity add value to the business?
Businesses aren’t static. They’re as dynamic as customers and, like customers, businesses evolve over time and their needs change. The question is whether or not what you’re doing evolves with the company’s needs?
Processes are created and modified to solve problems. Processes that fix today’s problems might not work two years from now—so continuing “business as usual” doesn’t make sense and usually drains the bottom line. An example: a company might implement a quality control process to fix a problem that happened with a few customers, but in retrospect realizes that this problem was very infrequent. The solution was “overkill” and continues to be a drain on the company. A less onerous quality control process could be implemented.
Another example: an executive prefers a certain report to be produced once a week. Said report takes five hours to be prepared. Fast forward and that same exec may no longer be with the company, but someone still runs that report because it’s become part of the process. No one has stepped back to investigate the value of running that report. No one has asked if it’s worth the hours per week it requires.
There are other examples, to be sure, but the thing to remember is this: every two years or so, it’s imperative to step back and ask why you do things the way you do, and if the way you’re doing things is valuable to the business. The majority of the time, your answer might well be “yes,” but even if you find that 10-15% of the time that the answer is “no,” you’ll be pinpointing ways to add value to the business.
5) Have you held on to your legacy IT systems too long?
Many mid-market businesses continue to run on legacy homegrown systems to manage financials, operations, sales, marketing and other needs. These systems were once necessary and worked well. In the past, enterprise software was designed and priced for large companies and internal systems were relatively isolated from the outside world. The evolution of SaaS platforms for every imaginable industry has changed this dynamic significantly. First, robust SaaS systems are now affordable for single proprietor small businesses up thru large global companies. You are never too small to have a great system. Implementation is fast and prices are based on the number of users. Second, this democratization of software has created a whole ecosystem of platforms your business needs to connect with. Payment systems, marketing analytics, and white label customer apps are just a few of the systems you can access with modern SaaS systems. It is no longer viable to remain competitive in your industry when your platforms are isolated from these ecosystems.
This is important, because so many profit improvement opportunities are tied to having the right systems If a company refuses to retire a homegrown system, it effectively walls itself off from the ability to maximize profits.
This requires a mental shift, to see the cost of new software not as an expense, but as a necessary investment to effectively and efficiently remain competitive in today’s ever-changing business world. It also requires the CEO to have the fortitude necessary to seek guidance from advisors who are not the CIO or CTO. In the mid-market, it is common to have a head of IT whose skills are tied to the legacy system that’s holding a company back. Migrating to SaaS platforms can be seen as a threat. It often takes an outside point of view to provide a balanced perspective.
Bonus Tip #1: Make a Habit of Internal Benchmarking
Imagine there’s a company with at-home call center employees and on-site call center employees. Now imagine you can analyze the numbers: how many calls are made by each group? How many sales? How big is the territory each covers?
By finding the people who do the most in the most efficient way, you can emulate their processes to help everyone else in the company reach the same standard. Find what’s different in the situation, what’s the same—this is how you uncover strengths and determine best practice.
In this case, our client learned that their at-home call center employees delivered more efficiently than their on-site call center employees. We considered reasons why this might be the case, so we could emulate those factors: maybe the at-home employees were better qualified; maybe they were happier because they worked from home. What insights does the benchmarking yield?
We have also used internal benchmarking with a client to determine why different managers had vastly different spans of control and found that our client had an unstructured way of bestowing titles; often a title was given to someone in lieu of a raise, or to praise a job well done—not because everyone with that same title had the same size territory or even job description. Analyzing the spans of control both made the structure more efficient and led to more standardized titles and responsibilities.
Bonus Tip #2: Review Procurement Processes At Least Every Two Years
Most companies are diligent about keeping tabs on large expenditures, but often smaller, recurring costs are overlooked, things like shipping fees or telephone/internet service provider rates or business insurance.
It’s prudent to re-shop vendors at least every two years. This might not mean that you change service providers, but it does mean that you hold your vendors accountable. We know from experience that companies that make noise and ask questions get better pricing. It’s rarely a silver bullet or the biggest part of the profit hunt puzzle, but there’s always something there—and having a process in place to review every two years helps uncover those gaps.