Profitability Analysis

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This article, discussing profitability analysis
in owner managed businesses, first appeared in
Better Business magazine. It is reproduced by
kind permission.
Mungo Dunnett Associates 11 Polstead Road, Oxford
OX2 6TW Tel [phone] Email
info_at_md-as.com Web www.md-as.com We operate
across a range of businesses, large and small.
Our focus is on ensuring that your activities
are geared towards the areas that are most
commercially valuable.
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September 2004
BY MUNGO DUNNETT
Understanding your firms profitability
I want you to feel good about yourself. Much of
the work that my firm does is with large
businesses big financial services companies,
professional service firms and the like. You
will be encouraged to know that, whilst they are
working like crazy to generate revenue, cut their
costs and generally shore up the bottom line, an
astonishing number of them cant properly
identify where their profit is being made.   The
truth is that most firms dont really understand
their profitability. They know what the figures
look like at the end of the year they know what
the sales levels are they certainly know what
the big outgoings are, such as payroll and
premises costs. But the actual profit the
thing that drives the whole enterprise forward?
Most often its only vaguely understood. And, if
you want to stick around for the long term and
make some serious money, thats not good enough.
But why does it so often happen?   Busy
fools   Youve got a busy firm. Everybody is
busy. Theyre engaged on revenue-generating work
or preparing for it, or prospecting for it.
But what if all this effort isnt actually The
truth is that most firms dont really
understand their profitability making the firm
any money? It might stagger you to identify what
proportion of any companys time is spent on work
that simply makes no money worth mentioning. One
of the most important pieces of information that
you or any business,
frankly must have at your fingertips is the
knowledge of where your profit is coming from.
And this, ultimately, is the purpose of good
management information it tells you what to do
to operate more effectively. This sounds so
obvious, yet in industry after industry companies
do not have this key There will be almost
nothing so important to the commercial viability
of your business information the information
that drives their bottom line at their
fingertips. Sometimes this is because the data
is deemed too hard to produce expensive,
time-consuming, and perhaps not worth the effort
or it is not considered sufficiently important
to alter the established working practices of the
business. And the result? Badly-informed
working practices that absorb too much of your
precious time but where you cant spare the
time to sort it out.   The extraordinary thing is
that, while the identification of profit is so
often considered to be some sort of black art,
its really not that complex, and certainly not
that costly to deliver. This may not be the most
exciting thing you will get involved in, but you
can bet your bottom dollar that there will be
almost nothing so important to the commercial
viability of your business.   First step moving
from billings to bottom line   The
traditional measure by which companies assess the
financial attractiveness of their customers (or
their products, or their services) is by top-line
billings the revenue that these things generate.
In companies
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where the sales function tends to dominate, sales
revenues are often the key measurement of the
companys success and the basis for salary
incentives and bonuses. Deeply flawed In
practice this whole approach is deeply flawed.
What it does is equate volume (the number of
units sold) with value (the money you make). It
also leads to all sorts of entirely dysfunctional
behaviour, such as price discounting to generate
greater sales (or market share) sporadic and
short-term You need a proper handle on the cost
to serve increases in sales volume which snarl
up your distribution or stock control processes
and the tendency to give the bulk-buying customer
what they want and if youre not sure quite
what they want, giving them extra service anyway
(which is an expensive thing to do). The guiding
principle again, deeply flawed is that margin
reductions, special deals, special service levels
and sale prices are justified because they keep
customers happy and lead either to increases in
revenue, or the protection of big sales
levels. Of course, there are all sorts of
reasons why price discounting is a bad idea
many of them to do with your long-term future in
your market but even in the short term,
decisions based on sales revenue rather than
profit are usually pretty poor ones. In
accounting terms, you need to move away from
top-line income (your revenues) and start to
focus on bottom-line profit. What this entails
is information about your actual operating
margins, with the inclusion of all your
significant costs and overheads. This means that
you need a proper handle on the cost to serve
the attributable cost of doing business with each
customer, including the
acquisition cost both in marketing and sales, and
the cost of handling, processing, and ongoing
servicing. In management accounting jargon,
this is the basics of activity based costing
but it is vital that this exercise is kept at a
relatively high level. Costing exercises can
descend into depths of analytical minutiae that
are utterly unnecessary for you something that
is adequately robust is all that you need in
order to stop the circular debates, and start
generating the big wins. After all, there is
little value in arguing indefinitely over the
fine detail of cost allocations when the company
continues to treat all customers profitable and
unprofitable alike. The work also involves
identifying the value of your lost customers
calculating the profitability of these
customers, Something that is adequately robust
is all that you need in order to stop the
circular debates, and start generating the big
wins through a combination of their billings,
the attributable costs, and the length of their
relationship with your company.   Identifying the
pareto skew   Youve probably heard of Wilfredo
Pareto. He was an Italian cleric at the end of
the nineteenth century, who was responsible for
one of the eureka moments in modern economics
the realisation that 80 of anything is typically
generated by 20 of the active agents. The
famous Pareto skew, therefore, says that in any
firm with non-standardised prices and sales
levels (and that will be your firm too), 20 of
the client base will be
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responsible for 80 of the profit. See graphic
The Pareto Effect This will be visible all over
your firms operations. The top 10 of your
sales will be generating a huge proportion of
your overall profit. The middle 50 or 60 will
be doing remarkably little for you apart from
absorbing 50-60 of your total costs, of course
and the bottom 10 are probably costing you a lot
of money to service. This information is sitting
dormant in your customer base. If you are not
able to identify those customers who prop up your
entire business and make absolutely certain you
are looking after them properly you can lose
profit with astonishing speed. By the same
token, if you are continuing to capitulate to
customers who may appear important, but who are
actually making you nothing or even losing you
money, you are destroying more of your own profit
every time you give in to their demands. And the
same thing applies to your sales and marketing
activities if you do not know which types of
customer (or product, or service) are the ones
that are vital to your profit, you will not know
what to focus your
new business sales on. As a rule of thumb most
of the profitable customers in any market are
already spoken for theyre somebody elses If
you are not able to identify those customers who
prop up your entire business and make
absolutely certain you are looking after them
properly you can lose profit with astonishing
speed customers already. That means that its
always easiest to acquire customers who are the
unprofitable ones because theyre the ones that
your smarter competitors are not interested in.
You need to make sure you know which customers
you really want, and which customers are simply
going to help the sales people hit their
target. Using databases properly   What you need
is a functioning database. Nothing fancy in
most
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owner-managed businesses the management
information that counts can be constructed on an
Excel spreadsheet, and for bigger businesses on
Microsoft Access. Into this you need to load
your client data (what they have bought, in a
single view across the range of your products or
services, and the billing dates) and the cost to
serve (as above). Now you can determine the
profitability of your customer base. Once the
customers are ranked in terms of their
profitability or potential profitability, which
is often an area where a knowledgeable salesforce
can add substantially to your decision-making
you can address several issues that deliver real
benefits for your efficiency and your bottom-line
profit.   The key benefits Identifying the
comparative profitability of recently acquired
customers, compared with recently-lost customers,
can indicate that sales efforts need redirecting.
Knowing which customers are generating the
greatest profit can help steer ongoing marketing
expense into acquiring more customers like these,
and less of those who are only Once the
customers are ranked in terms of their
profitability, you can address several
issues that deliver real benefits for your
efficiency and your bottom-line
profit marginally profitable, or who are
actually generating a loss. Servicing and
processing costs and the systems requirements
underpinning the customer processing activities
can similarly be geared towards attracting and
keeping only the most profitable customers,
rather than being diluted by attempting to raise
the bar for all.
This applies to whatever size of business you
happen to be. Pareto will be there, whether you
have 100 customers buying 5 products, or 100,000
buying 1,000.   Acting on it   The fate of
management information, particularly in bigger
companies, is often that the results it produces
are simply too challenging to be palatable. A
decent profitability exercise will This
analytical process is usually the single most
cost-effective exercise any firm can
undertake indicate where you should be focusing
your money what type of investment is needed in
products, service, sales and marketing, customer
servicing and every other part of your cost base.
It becomes so much easier to make your
management decisions, because you know with
certainty where your profit is coming from and
therefore which parts of your operation you
really need to be focusing on. You need
information real facts that will let you make
decisions about what the firm does, and how it
operates, with proper confidence. This is where
IT really earns its corn. The secret, as with
all IT investment, is not expensive systems.
Its understanding what you want to achieve,
doggedly making sure the data is correct and
then getting off the fence and implementing the
findings. This analytical process is usually the
single most cost-effective exercise any firm can
undertake. Want to make more profit? Find out
where its coming from.