Do you know, really know, which activities of your business are generating profit and which are stealing it away?
Most CEOs and CFOs immediately answer “yes, of course” – and they are, more often than not, wrong.
In his book “Islands of profit in the sea or red ink”, Jonathan S. Byrnes presents his observation that 40% of pretty much any given business is unprofitable. Since I do not have the same depth of research backing my claims, I must concur – although anecdotally, I often see a figure much larger.
How is that even possible?!
The practice of cost attribution at the order line level, while being absolutely essential for a meaningful profitability analysis, is far from common. Way too much becomes lost in overhead, and profitability thinking ends (in better cases) with gross profit. At least those following Greg Crabtree’s book “Simple Numbers” (you should) add direct labor. And yet, even this addition is generally done only on an aggregated level rather than down to the order line item.
Yes, I’m pretty sure Amazon or Walmart itemize their expenses quite well, as they would not be able to drive their aggressive pricing policy otherwise. Do you need to be as big and successful as they are to be able to benefit from such analysis, or do you need such practice in order to be as successful as you can be?
The technology and thinking has evolved quite a bit since Byrnes wrote his book (and it shows as you read it), but the principles remain the same. If anything, it has become immeasurably easier to put his thoughts into practice. Chances are, the data is already there, and just needs to be looked at the right way.
What is a Profit Map? It is a chart (well, table) that shows real profit on the intersections of products (or product groups) and accounts/customers (or their groups). How much is selling product or service A, to customer cohort 3, contributing to our overall profit? Or, how much of a drain does it represent?
Imagine what kind of insights can such a map provide, especially if you layer in the team responsible. There is usually someone who owns each column – account manager – and each row – line or product manager.
You will immediately spot any patterns. Which product groups are we doing well with? Which accounts, and most importantly, what combinations thereof are the best? Is there a vendor or manager correlation? Are we putting too much effort into the wrong places, instead of doubling down on areas working really well?
The key to making the map meaningful is, of course, the way overall costs are attributed to each line; which then is aggregated into the map’s cell. What must be avoided is attributing costs equally based solely on top-line revenue. That approach is largely meaningless, as it may simply indicate that an order failed to generate enough margin to cover the average indirect costs. Much more insight comes from more sophisticated attribution models applied for each cost line. Often, there is an estimate or educated guess involved in the model, but that’s OK. Even at 70% or 80% accuracy, the map starts showing areas where to dig for treasure.
Here are a few ideas of how to think about the attribution models:
For management labor – what percentage goes to particular accounts or teams?
For marketing – any campaigns or activities directly related to particular brands or products? Co-marketing with customers?
Cost of capital – how much is tied into inventory of given items? How much is in A/R for each customer?
Banking charges – who pays by credit card versus who pays by transfer?
This list could go much longer, but you get the point. Start from the big cost items first, work your way down, refine as you go. Keep using the map, and challenge the assumptions going into it.
I’m certain your bottom line will thank you.
