Changing the Emphasis from Sales/Revenue to Margin/Profits
Sales/revenue/cash are the primary metrics for entrepreneurial companies. Whether the company is relying on self-generated cash or investments/loans, the creation of critical mass in terms of sales volume and revenue is paramount.
Speed to market, revenue growth, and a sexy product were the major investment criteria.
Profitability requires a lot more than a shift in emphasis.
If the company has stressed revenue, it likely created an expectation in the sales channels of ''sales at any cost.'' Since most sales organizations of entrepreneurial/early growth spurt companies were not compensated on margin, there was little incentive to focus on anything except making the sale ... any sale. Discounts were requested and likely granted. Special promotions became the norm, not the exception. Sales expenses crept up because growing the customer and revenue base was all important.
Efforts at margin management were probably focused on the ''buy side'' of the equation. Purchasing (as purchasing has and will always do) hammered suppliers to obtain the best possible cost of goods. However, little attention was given to the ''sell side'' of the margin equation.
The company attracted any kind of customer, but regrettably, some customers were acquired and retained at a terribly high cost. Some sales channels' costs of acquisition went through the roof: more sales reps were required than anticipated; ''close'' rates on telemarketing calls were below target; there was a requirement to boost agent compensation; nonbudgeted advertising expenses crept in, and so on. The combination of reduced prices demanded by the customers and greater selling effort required to acquire them dwarfed the operating expenses forecast in the budget. To make matters worse, some customers required significantly more support during implementation of the sale. And, once implementation was complete, the ongoing customer service requirements of some customers went far beyond what anyone had anticipated. None of these additional costs were anticipated in the budget.
Revenues are on target, but all of a sudden the company finds itself hit with a triple whamo that's deteriorating profitability:
? Revenues per customer have declined due to aggressive discounting and promotions.
? Sales expenses have gone up; you have to have more customers than anticipated if the projected revenue-per-customer goes down.
? General & Administrative (G&A) expenses go up due to higher than expected costs of implementation and customer support.
With the ''triple whamo,'' the company arrives at some basic conclusions:
? All customers/revenue/sales are not equal.
? All products are not equal.
ALL CUSTOMERS/REVENUE/SALES, AND PRODUCTS, ARE NOT EQUAL
Larry Selden and Geoffrey Colvin in their book Angel Customers & Demon Customers put forth their ''150–20 rule'':[1]
? 150 percent of companies' profits come from less than 20 percent of their customers.
? The bottom 20 percent may lose money equal to 150 percent of profit.
? The remaining 60 percent of customers make up the difference.
Mitch Rosenbleeth of Booz-Allen & Hamilton recounts a recent experience with a client where 30 percent of a company's customers created 200 percent of its profits. Half of the customers produced little profit, and the remaining 20 percent ''destroyed profits.
Unprofitable customers, similar to churning customers, are another one of those silent killers that can prove fatal if not detected and jettisoned early on.
What Makes for Unprofitable Customers?
A main contributor, in a word, is averaging. Be it gross margin calculations, prorating of overhead expenses, or distribution of sales/marketing expenses, averaging can produce very distorted numbers; this distortion, again, is related to the degree of disparity among the elements being averaged.
Potential ''Problem-Maskers'' Average Gross Margin: Though addressed separately in the next section, disparate product/product line margins have obvious implications on profitability. Different production/purchasing costs and other inherent ''cost-of-goods/services'' elements may drastically distort average margins. And, with different products producing different margins, the profitability of products purchased by a customer will vary greatly.
Average Sales/Marketing Expense: Simply dividing all sales/marketing costs by orders or products sold produces an average that is likely quite unrepresentative of customers who soak up an either unusually high or low share of the sales/marketing costs. This is especially true if multiple channels (direct sales, telemarketing, etc.) are utilized.
Average Purchase: Some customers buy in large quantities, requiring only one order to be processed and only one bill rendered. Others are just the opposite: many small orders and many bills. And collectively, all of the smaller multiple purchases may not equal a fraction of a large user's order.
Average Support Costs: This is perhaps the most difficult element to get a handle on. However, whether by design or otherwise, customers require a disproportionate share of support. Some never call with a complaint or service problem. Others call weekly. Some large customers may demand higher levels of service in return for their business; others don't. Assuming that all customers require the same amount of attention, and thus should share an equal allocation of the costs, is refusing to acknowledge the obvious.
Average Days of Receivables: Everyone measures this. All businesses have their 30/60/90/120-day reports. Though an indicator of a company's general financial health, do you really know, at the individual customer level, who's either not paying you or paying you late? And, do you know what it's costing you in profits?
Beware: Major Accounts
The following is a representation of a company that hailed its major account programs and urgently stressed the desire to add more to its customer list.
? Higher sales commissions were paid to sellers who acquired major accounts.
? A separate sales force was dedicated to acquiring major accounts; this move was necessary in order to provide the resources required to develop complex proposals and respond to bid requests.
? Special sales collateral was developed to assist in acquiring new major accounts.
? A discount pricing schedule was developed especially for major accounts; some discounts offered went beyond the schedule.
? Major accounts, as a group, purchased the least profitable products sold by the company.
? The major accounts demanded and received dedicated service personnel.
? The major accounts consistently requested product delivery intervals shorter than those normally offered by the company.
? Sometimes the smallest breakdown in service delivery by the company resulted in executive-level complaints from the major accounts.
? The major accounts required a special billing format that the company had to customize and support.
? The major accounts were consistently slow to pay and constantly disputed the bills rendered.
What To Do?
a) De-average!
Every organization's analytical and systems capabilities are different, but senior management should force de-averaging of key indicators/results as broadly and as deeply across the organization as possible. We think you will be surprised at what can be accomplished simply by asking for it. You may never get to the level of individual customer profitability, but you can certainly move in that direction.
Think in terms of segments or groups, not the whole. Identify the common characteristics among certain customer or prospect groups. Initially you may have to ''guesstimate'' prorates and loadings; there is a point of diminishing returns for efforts to precisely allocate shared costs. But, a zillion-dollar cost allocation system isn't required to develop a reasonably accurate profitability model for the various segments or groups.
b) Existing Unprofitable Customers
Once you get a handle on which customers are profitable and which aren't, the task then becomes to turn the latter into the former. The options available are obvious ... increase prices, lower costs, or devise some combination of the two. The goal will be to retain the customer, but only if the level of profit contribution achieves a threshold acceptable to the company.
c) New Unprofitable Customers?
Dealing with a group of unprofitable legacy customers isn't pleasant, but it's necessary in order to solve problems originating from prior sins. However, the sinning cannot continue.
What about Products?
Thomas K. Brown writing in Bank Director magazine cites consultants Mercer Oliver Wyman in pointing out the disparity of product line profitability of banks:[3]
? The top 10 percent most profitable products generate 70 percent of overall product profits.
? The bottom 80 percent contribute less than 1 percent of profits.
A midsize service company with which we are familiar had gross margins ranging from 75 percent to minus 30 percent for its various products.
Therefore, if a company has more than one product, the ''averaging'' of product/product line profitability harbors similar potential for ''problem-maskers,'' as does averaging of customer profitability.
Alternative Approaches
The following identifies some rather unorthodox approaches to looking at a company's financials.
ABC
A. A Bill of Activity is created that lists all the activity costs directly traceable or consumed by the product, service or customer.
B. Non-traceable business sustaining activities, such as ''Do Monthly Closing,'' are then allocated to the Bill of Activity.
C. Traceable costs þ Non-traceable costs þ Profit = Sales Price.
SALES VERSUS MARKETING: BALANCING REVENUE AND PROFIT PRIORITIES
Sales' job is to sell, to sell the products it has been provided at the prices the company has established.
Marketing: Among other things, it is the keeper of the margin keys. As one of its most important responsibilities, marketing establishes prices and monitors (or should) the all-important ''sell side'' of the gross margin of the business. Coupled with stringent purchasing/production cost management, marketing must bring focus to the sometimes no-fun analysis of profitability emphasis to balance the sexier, more glamorous revenue emphasis.
If the sales organization has historically been the major player in the establishment of pricing and discounting policies, it will be very reluctant to give up those prerogatives. Sales' job has been to sell, and setting competitive prices and offering appealing discounts to the sellers is a sure way to increase sales volume and revenue. And, that goal may well have been paramount in the past. However, at some point the organization will begin to emphasize profitability, and, barring the fairly rare situation where sales compensation is based more on profitability than revenue, leaving pricing and discounting decisions in the hands of the sales organization is, simply, a mistake.
Checks and Balances
Organizations must constantly assess the strategic value of revenue growth and profitability. The two need not necessarily be mutually exclusive, but in most industries the lower the price, the more you sell; the higher the price, the more profit you make.
At different stages of a company's evolution, the strategy may favor one over the other (if you can't have both.) Acquiring market share will favor lower prices. A forecast of hard economic times on the horizon will encourage cash accumulation and higher prices and profits. And, of course, competitors have more than a little impact on your pricing policies.
But, no matter the strategic driver at any given time, advocates of both the low price/high sales volume and higher price/higher profit positions should be provided a forum to debate and substantiate their respective points of view, with facts, figures, and analysis.
Sales can't be sure of the negative or positive impact on volume of a price increase or decrease. Marketing might produce spreadsheets that indicate the impact of a price change, but only if their volume assumptions are accurate. And, what will the competitors do as a result of a price change? It's all a matter of conducting the best analysis possible and applying the aggregate judgment of those involved in making the decision.
However, the point here is that the debate must occur. The analyses must be made. Those who represent ''lower price/revenue growth'' and others in the ''higher price/higher profit'' camps must have equal representation and clout in the debate. The outcome should not be preordained, barring some overwhelming strategic imperative. Each side should be prepared to offer its best case and do so. The absence of any compelling fact or argument, on either side, could lead to a less than optimum decision.
For more Information
* Business Success and Wisdom, Business Collaboration, Business Planning *
Sales/revenue/cash are the primary metrics for entrepreneurial companies. Whether the company is relying on self-generated cash or investments/loans, the creation of critical mass in terms of sales volume and revenue is paramount.
Speed to market, revenue growth, and a sexy product were the major investment criteria.
Profitability requires a lot more than a shift in emphasis.
If the company has stressed revenue, it likely created an expectation in the sales channels of ''sales at any cost.'' Since most sales organizations of entrepreneurial/early growth spurt companies were not compensated on margin, there was little incentive to focus on anything except making the sale ... any sale. Discounts were requested and likely granted. Special promotions became the norm, not the exception. Sales expenses crept up because growing the customer and revenue base was all important.
Efforts at margin management were probably focused on the ''buy side'' of the equation. Purchasing (as purchasing has and will always do) hammered suppliers to obtain the best possible cost of goods. However, little attention was given to the ''sell side'' of the margin equation.
The company attracted any kind of customer, but regrettably, some customers were acquired and retained at a terribly high cost. Some sales channels' costs of acquisition went through the roof: more sales reps were required than anticipated; ''close'' rates on telemarketing calls were below target; there was a requirement to boost agent compensation; nonbudgeted advertising expenses crept in, and so on. The combination of reduced prices demanded by the customers and greater selling effort required to acquire them dwarfed the operating expenses forecast in the budget. To make matters worse, some customers required significantly more support during implementation of the sale. And, once implementation was complete, the ongoing customer service requirements of some customers went far beyond what anyone had anticipated. None of these additional costs were anticipated in the budget.
Revenues are on target, but all of a sudden the company finds itself hit with a triple whamo that's deteriorating profitability:
? Revenues per customer have declined due to aggressive discounting and promotions.
? Sales expenses have gone up; you have to have more customers than anticipated if the projected revenue-per-customer goes down.
? General & Administrative (G&A) expenses go up due to higher than expected costs of implementation and customer support.
With the ''triple whamo,'' the company arrives at some basic conclusions:
? All customers/revenue/sales are not equal.
? All products are not equal.
ALL CUSTOMERS/REVENUE/SALES, AND PRODUCTS, ARE NOT EQUAL
Larry Selden and Geoffrey Colvin in their book Angel Customers & Demon Customers put forth their ''150–20 rule'':[1]
? 150 percent of companies' profits come from less than 20 percent of their customers.
? The bottom 20 percent may lose money equal to 150 percent of profit.
? The remaining 60 percent of customers make up the difference.
Mitch Rosenbleeth of Booz-Allen & Hamilton recounts a recent experience with a client where 30 percent of a company's customers created 200 percent of its profits. Half of the customers produced little profit, and the remaining 20 percent ''destroyed profits.
Unprofitable customers, similar to churning customers, are another one of those silent killers that can prove fatal if not detected and jettisoned early on.
What Makes for Unprofitable Customers?
A main contributor, in a word, is averaging. Be it gross margin calculations, prorating of overhead expenses, or distribution of sales/marketing expenses, averaging can produce very distorted numbers; this distortion, again, is related to the degree of disparity among the elements being averaged.
Potential ''Problem-Maskers'' Average Gross Margin: Though addressed separately in the next section, disparate product/product line margins have obvious implications on profitability. Different production/purchasing costs and other inherent ''cost-of-goods/services'' elements may drastically distort average margins. And, with different products producing different margins, the profitability of products purchased by a customer will vary greatly.
Average Sales/Marketing Expense: Simply dividing all sales/marketing costs by orders or products sold produces an average that is likely quite unrepresentative of customers who soak up an either unusually high or low share of the sales/marketing costs. This is especially true if multiple channels (direct sales, telemarketing, etc.) are utilized.
Average Purchase: Some customers buy in large quantities, requiring only one order to be processed and only one bill rendered. Others are just the opposite: many small orders and many bills. And collectively, all of the smaller multiple purchases may not equal a fraction of a large user's order.
Average Support Costs: This is perhaps the most difficult element to get a handle on. However, whether by design or otherwise, customers require a disproportionate share of support. Some never call with a complaint or service problem. Others call weekly. Some large customers may demand higher levels of service in return for their business; others don't. Assuming that all customers require the same amount of attention, and thus should share an equal allocation of the costs, is refusing to acknowledge the obvious.
Average Days of Receivables: Everyone measures this. All businesses have their 30/60/90/120-day reports. Though an indicator of a company's general financial health, do you really know, at the individual customer level, who's either not paying you or paying you late? And, do you know what it's costing you in profits?
Beware: Major Accounts
The following is a representation of a company that hailed its major account programs and urgently stressed the desire to add more to its customer list.
? Higher sales commissions were paid to sellers who acquired major accounts.
? A separate sales force was dedicated to acquiring major accounts; this move was necessary in order to provide the resources required to develop complex proposals and respond to bid requests.
? Special sales collateral was developed to assist in acquiring new major accounts.
? A discount pricing schedule was developed especially for major accounts; some discounts offered went beyond the schedule.
? Major accounts, as a group, purchased the least profitable products sold by the company.
? The major accounts demanded and received dedicated service personnel.
? The major accounts consistently requested product delivery intervals shorter than those normally offered by the company.
? Sometimes the smallest breakdown in service delivery by the company resulted in executive-level complaints from the major accounts.
? The major accounts required a special billing format that the company had to customize and support.
? The major accounts were consistently slow to pay and constantly disputed the bills rendered.
What To Do?
a) De-average!
Every organization's analytical and systems capabilities are different, but senior management should force de-averaging of key indicators/results as broadly and as deeply across the organization as possible. We think you will be surprised at what can be accomplished simply by asking for it. You may never get to the level of individual customer profitability, but you can certainly move in that direction.
Think in terms of segments or groups, not the whole. Identify the common characteristics among certain customer or prospect groups. Initially you may have to ''guesstimate'' prorates and loadings; there is a point of diminishing returns for efforts to precisely allocate shared costs. But, a zillion-dollar cost allocation system isn't required to develop a reasonably accurate profitability model for the various segments or groups.
b) Existing Unprofitable Customers
Once you get a handle on which customers are profitable and which aren't, the task then becomes to turn the latter into the former. The options available are obvious ... increase prices, lower costs, or devise some combination of the two. The goal will be to retain the customer, but only if the level of profit contribution achieves a threshold acceptable to the company.
c) New Unprofitable Customers?
Dealing with a group of unprofitable legacy customers isn't pleasant, but it's necessary in order to solve problems originating from prior sins. However, the sinning cannot continue.
What about Products?
Thomas K. Brown writing in Bank Director magazine cites consultants Mercer Oliver Wyman in pointing out the disparity of product line profitability of banks:[3]
? The top 10 percent most profitable products generate 70 percent of overall product profits.
? The bottom 80 percent contribute less than 1 percent of profits.
A midsize service company with which we are familiar had gross margins ranging from 75 percent to minus 30 percent for its various products.
Therefore, if a company has more than one product, the ''averaging'' of product/product line profitability harbors similar potential for ''problem-maskers,'' as does averaging of customer profitability.
Alternative Approaches
The following identifies some rather unorthodox approaches to looking at a company's financials.
ABC
A. A Bill of Activity is created that lists all the activity costs directly traceable or consumed by the product, service or customer.
B. Non-traceable business sustaining activities, such as ''Do Monthly Closing,'' are then allocated to the Bill of Activity.
C. Traceable costs þ Non-traceable costs þ Profit = Sales Price.
SALES VERSUS MARKETING: BALANCING REVENUE AND PROFIT PRIORITIES
Sales' job is to sell, to sell the products it has been provided at the prices the company has established.
Marketing: Among other things, it is the keeper of the margin keys. As one of its most important responsibilities, marketing establishes prices and monitors (or should) the all-important ''sell side'' of the gross margin of the business. Coupled with stringent purchasing/production cost management, marketing must bring focus to the sometimes no-fun analysis of profitability emphasis to balance the sexier, more glamorous revenue emphasis.
If the sales organization has historically been the major player in the establishment of pricing and discounting policies, it will be very reluctant to give up those prerogatives. Sales' job has been to sell, and setting competitive prices and offering appealing discounts to the sellers is a sure way to increase sales volume and revenue. And, that goal may well have been paramount in the past. However, at some point the organization will begin to emphasize profitability, and, barring the fairly rare situation where sales compensation is based more on profitability than revenue, leaving pricing and discounting decisions in the hands of the sales organization is, simply, a mistake.
Checks and Balances
Organizations must constantly assess the strategic value of revenue growth and profitability. The two need not necessarily be mutually exclusive, but in most industries the lower the price, the more you sell; the higher the price, the more profit you make.
At different stages of a company's evolution, the strategy may favor one over the other (if you can't have both.) Acquiring market share will favor lower prices. A forecast of hard economic times on the horizon will encourage cash accumulation and higher prices and profits. And, of course, competitors have more than a little impact on your pricing policies.
But, no matter the strategic driver at any given time, advocates of both the low price/high sales volume and higher price/higher profit positions should be provided a forum to debate and substantiate their respective points of view, with facts, figures, and analysis.
Sales can't be sure of the negative or positive impact on volume of a price increase or decrease. Marketing might produce spreadsheets that indicate the impact of a price change, but only if their volume assumptions are accurate. And, what will the competitors do as a result of a price change? It's all a matter of conducting the best analysis possible and applying the aggregate judgment of those involved in making the decision.
However, the point here is that the debate must occur. The analyses must be made. Those who represent ''lower price/revenue growth'' and others in the ''higher price/higher profit'' camps must have equal representation and clout in the debate. The outcome should not be preordained, barring some overwhelming strategic imperative. Each side should be prepared to offer its best case and do so. The absence of any compelling fact or argument, on either side, could lead to a less than optimum decision.
For more Information
* Business Success and Wisdom, Business Collaboration, Business Planning *
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