How to manage portfolio profitability
Inspiration
How to manage portfolio profitability
Managing profitability is a big challenge in any portfolio of customers, products or markets. However, it tends to be approached in ways that suffer from complexity and slow results. Shortcutting the process and adopting a more top-down approach can provide insights that will lead to substantial profit improvements. By John Glottrup and Brian Nordlund Nielsen
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How to manage portfolio profitability Effective management of profitability across any portfolio of customers, markets or products is a key lever for value creation – regardless of economic climate or industry. Downturns may underpin the need to understand where profits are created or lost. Yet even in positive market conditions, the returns from working detailed and effectively with profitability are substantial. Quartz Strategy Consultants has worked strategically with profitability management in a number of industries over the last ten years. In the process, we have developed a simple, yet comprehensive approach that can deliver substantial results within a limited time frame. Our approach is businessdriven and should include the following key elements: 1. Explicit prioritisation of time, resources and accuracy in order to deliver optimal business impact 2. Robust and comprehensive frameworks that can be improved continuously 3. Pragmatic, operational tools and end products Many businesses have thousands or even millions of customers and offer a diverse range of products or services through a number of different channels. IT systems typically support the daily operations of these complex structures. Equally, classical financial accounting makes the necessary information available to drive the business as a consolidated entity. However, when it comes to discussing the profitability of individual segments, customers or products below
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contribution level, we often see companies meet their match. When businesses need to find out where profits are generated, or whether costs outweigh income within some activities, they typically go down one of two routes: •
They either choose to do an ad hoc analysis on top of the everyday work, carried out by someone in the finance department. This may provide the business with some insights, but it is often too far from the day-to-day operations, which makes it difficult to translate into concrete actions
•
Other businesses make a detailed study of activities, costs and key drivers to be incurporated in the IT or financial system. The study is supposed to enable detailed analysis and ongoing reporting on profitability. This approach seemingly promises strong and robust tools that can be applied continuously; however, these large-scale efforts tend to run out of steam and fail to deliver the expected tangible results
So what is the alternative if you want to avoid the pitfalls of a dispersed ad hoc analysis or comprehensive and long-lasting efforts proving "precisely wrong"?
01. Prioritisation How tight a grip on profitability is really needed to take the business effectively forward? Requirements and urgency vary according to industry and company, and a solid understanding of the business agenda and challenges is pivotal in turning efforts into effective results. In any company, the finance function is expected to deliver flawless and completely accurate information. Strong and seasoned finance people know when and how to cut corners or make judgement calls to take things forward. Still, it is essential to facilitate this process not only by involving the finance function, but also the line organisation. It is a priority for the entire business to improve profitability strategically, and therefore focus, scope and organisation of work should always be organised with this in mind. Early involvement paves the way for later discussions of the outcome of various analyses and makes it easier to generate recommendations for strategic actions to be taken. In other words, if you hear the business out in the early phases, moving to concrete actions will be much easier later on. Once the strategic context and key priorities are defined, the required degree of accuracy should be carefully evaluated against the required time needed to provide results. "More accurate" is not always better when the agenda is to strategically improve profitability. Speed will often be more important than accuracy; fast decisions made on the basis of good approximations have a higher payoff for the business than slower decisions based on highly accurate analyses.
How to manage portfolio profitability How to manage the speed/certainty tradeoff for different parts of the value chain is illustrated in figure 1. The model includes five key criteria to be used when the need for accuracy versus time and resources is considered. Making this discussion explicit is often a valuable experience in itself. If a business scores low on all five dimensions, a very simple top line or contribution level model may be sufficient. We have seen
very simple models provide substantial results. With one business a "traffic light" system on customer profitability levels coupled with sales staff compensation was all the company needed to significantly raise profits. On the other hand, if a business scores high on all five dimensions, prioritisation is necessary. There are no single right answers, but often even the discussions of how to prioritise makes the organisation
begin to think about and act on profitability. If strategic decision-making on portfolio profitability is the goal, the time frame should be counted in weeks. Ambitious initiatives with longer duration may sometimes be required, but Quartz would always challenge large, monolithic initiatives. These initiatives are likely to be more effective if sliced into smaller and more manageable chunks.
Figure 1: Five criteria that should be considered before determining the desired level of accuracy in the profitability system.
Time available to do the analysis Low
Predominately top line or simple contribution system
Variations in fixed costs consumptions by activity Low
Relatively simple system Comprehensive system High accuracy of system
Low Need for certainty in decision making
Low
Low Share of total costs below contribution level
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Variations in pricing and discounts between customers or products
How to manage portfolio profitability 02. Robust and comprehensive frameworks Building strong insights should begin with defining a model of the business based on the performed activities rather than a standardised financial account plan. This model should contain a robust view on income. Most businesses have relatively detailed information available down to contribution level, but we sometimes come across businesses where more work on the allocation of discounts is required. Getting the right information on income and discounts is crucial. Once gross and net income numbers are robust and a business model has been defined, key cost pools for different activities should be identified along with associated cost drivers. The degree of detail needs to be managed carefully in this process. The overall business objectives (and explicit decisions on trade-offs on accuracy versus resources) should guide the work when one decides how different cost pools and cost drivers should be addressed. In order for models to be operational, one additional dimension needs to be considered. Execution on priorities may often happen at a relatively low level of the organisation. Thus, drilldowns on profitability by channel, product, segment or individual customers are required. Put shortly, the model needs to be built from the bottom in order to be understood from the top. This does not mean that everything should be detailed to the lowest possible level from the outset, but merely that the possibility of going into detail later on should be kept open in the design of the model.
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A robust and approximately correct model that can be improved continuously is far more valuable than an accurate answer that may take much more time to produce.
03. Pragmatic and operational tools and end products Sophisticated insights are worthless if they are not translated into concrete actions, or if the business is not capable of executing on defined priorities. In our work, we sometimes hear the comment: "we knew that already" when key findings are uncovered. Challenging this kind of argument is pointless. Instead, all efforts should be focused on answering why no one has acted on key insights that already existed. The web offers thousands of hits on the search term "profitability management tools". Indeed, there are plenty of systems, software and methodologies to buy out there, so why is it that difficult for many businesses to understand and act on profitability at a detailed level? Our experience has taught us that other danger zones are transparency and involvement. Tools need to be simple enough for outsiders to understand, and, as mentioned above, managers with P&L responsibilities must be involved in the process. Would any channel or product manager implement strategic recommendations from an advanced costing or profitability system? The system being more or less a black box to people outside the finance department. Today, standard spreadsheets offer a very rich functionality. In most cases, they can handle the complexity and amount of data needed for the first and most value-creating
steps in managing profitability. Spreadsheet models are easy to build, change and explain. Furthermore, they form an excellent starting point for any future project about integrating profitability into IT or financial systems. Therefore, a fast and business-driven process, supported by a number of well-substantiated spreadsheets, is the best starting point for most initiatives related to profitability management. Last but not least, it is important that progress on the execution of priorities can be tracked. Equally, it is important that models can be updated to illustrate progress against strategic priorities. Standardised initiative and targeting lists at a fairly detailed level are necessary if profitability initiatives should have a real impact.
Managing profitability makes an impact Insight into profitability at detailed levels enables initiatives that drive efficiency as well as growth. Impact obviously varies by industry, customer and situation. We have seen profit improvements from two to three per cent in highly competitive environments to several hundred per cent. Furthermore, profitability insights often pave the way for more fundamental discussions of route to market or pricing, for example. An illustration of the outcomes of a strategic profitability model is shown in figure 2 (page 6). A tail analysis of for example customers, channels or products is a strong point of departure for discussing profit improvements. All portfolios have tails, but often businesses have a surprisingly high number
How to manage portfolio profitability of loss-making customers or products. We have seen tails predominantly caused by one factor, for example consistently high logistics costs in one channel. This meant that the right course of action was to adjust logistics service levels in order to match channel preferences against cost to serve. We have also seen tails caused by several factors, such as pricing, marketing and sales force. In these cases, the right answer was to acknowledge that a proportion of cus-
tomers were fundamentally unattractive in the current service model. A distributor set-up was likely to be more attractive. Just getting rid of the tail is seldom the most productive answer. One should take a closer look at the components that lie behind the tail. This means drilling down to detailed profitability views by customers, products or channels. The individual P&Ls can easily be generated in a standard spreadsheet model which will often provide the business with
completely new insights. As insights are available at all levels of the portfolio, a standardised targeting list with concrete customers is often very effective. The targeting list should contain a clear indication of actions to be taken at customer level. It should also be divided into sub-lists, e.g. region and sales representation level. It is a lot easier to drive and follow up on initiatives when the business has just one tool for driving and tracking initiatives related to improvements to profitability.
Figure 2: Typical outcomes of strategic profitability initiatives.
Tail analysis of portfolio profitability …
… can be used to identify candidates for detailed analysis of customer, channel and product profitability …
… which is the base for ensuring frontline execution
Tail analysis to evaluate the customer or product portfolio
Profitability views on customers, products and channels
Target lists to be used in improving individual customers' profitability Improvement potential
Channel N
Profit
Product X
Total Customer Discounts Logistics Sales Marketing Other potential
Customer A Value creating customers
Profitability Per cent
20
Discounts 80
Net sales
30
COGS
Unprofitable customers
15
Logistics 5
Marketing 5
Sales force
6
0
2,500
0 5,000 0
2,000 0
0
0 12,000 2,500
C
0
0
0
3,000
2,000
5,000
D
0
0 5,000
2,000
0
7,000
E
0
0
0
0
0
0
F
0
0 2,000
0
2,000
4,000
G
6,000
0
0
0
0
6,000
H
0
0
0
0
0
0
I
0
0
0
3,000
2,000
5,000
J
0
0
0
3,000
0
3,000
15
Other Profit
5,000
B
100
Gross sales
Customers
A
10
How to manage portfolio profitability
Questions for effective portfolio profitability management Managing profitability across a portfolio of customers, products or markets is a challenge to many businesses. Often efforts to generate new insights and apply new tools suffer from complexity and the amount of time before they provide results. In our experience, a few critical questions can provide guidance as to whether your business could improve by adopting a more top-down approach to profitability management. If your answer to more than a few of the questions below is "no", it is probably worthwhile considering a new approach to managing profitability: x Does your business have a fact-based view on net profitability across most important dimensions (products, channels, segments, customers)? x Does your business run programmes to strategically manage profitability, e.g. by working on discounts or cost to serve with specific segments? x Is managing profitability a priority outside the finance department?
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x Are customer service levels or support aligned with customer value to the business? x Do your models allow for tracking progress against defined priorities at a detailed level (e.g. customer level)? x Is any of your staff rewarded on the basis of profitability targets? x Do you work with continuous refinement and development of models and tools?
How to manage portfolio profitability
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