Robert Kugel's Analyst Perspectives

One of the oddities of corporate management is that, as a rule, nobody oversees managing profitability. CEOs are accountable for meeting company-wide financial targets and assign responsibility for achieving profitability levels to business unit owners across and down an organization. Sales quotas designed to achieve revenue goals are put in place, and budget owners have cost and margin objectives. But setting profitability objectives is not the same as managing profitability.

Profitability management is a cross-functional effort that integrates finance and sales to achieve an optimal balance of revenue and margin objectives. This is a more effective performance management tool because it is a data- and analytics-based approach designed to consistently achieve higher sales and fatter margins. Ventana Research asserts that by 2025, one-third of organizations will have implemented a profitability management initiative.

Such an initiative involves parallel efforts by the Office of Finance and the sales organization. The first, handled by financial planning and analysis (FP&A), requires establishing and running a profit analytics program. The analytics provide the rest of the organization with consistent and reliable detailed information about product, customer and channel profitability to support better decisions about pricing, product bundling, sales quotas, incentive compensation and production. The second is supporting a price and revenue management structure in the sales organization that achieves an optimal trade-off between revenue and margin. Organizations that use software to gain better insight into a buyer’s willingness to pay can set the highest possible price in a transaction with the greatest likelihood of getting the business.

Profitability management is an analytics-driven business discipline designed to enable organizations to achieve superior market share and profitability objectives. At the heart of the challenge is the ability to quantify the profitability of specific products, customers and channels and every permutation of these three. That does not happen in most companies today. Our Office of Finance benchmark research found that only 34% manage customer profitability, and just 30% of companies manage product profitability.

Profitability is determined by revenues minus costs, so it is axiomatic that organizations must have a full understanding of the true economic costs of their products, customers and channels. The organization must then use these insights to drive decisions about pricing, marketing, quotas, territories and incentive compensation. Both efforts rely on software to deal with large data sets and often complex analytics to achieve the best results in dynamic market conditions.

Economic costing measures are a better approach to understanding profitability than using accounting-based metrics. Statutory accounting is designed for financial, not operational management. Accounting costs can be abstract and divorced from economic costs and cash flow. Financial accounting suffers from basic analytical issues such as sunk-cost fallacy. Organizations that have a deeper, more economically accurate understanding of all their costs are better able to control them. And in being able to control them, they can manage in a way that is consistent with their strategy, resources and market position.

Revenues are a function of units sold times the price per unit. Setting that price can be challenging. The most straightforward and longstanding approaches to price setting are a cost-plus calculation, or just charge what competitors are charging. More recently, though, demand-based pricing has achieved a following because technology makes this approach practical. Demand-based pricing uses an estimate of the good’s or service’s perceived value to the buyer as the central element in setting prices. Demand-based pricing enables a company to reliably achieve higher revenues and higher margins than other approaches because it is based on the buyer’s willingness to pay. Charging more when the buyer is willing to pay produces higher profits without sacrificing revenue and market share.

At the heart of demand-based pricing is a price and revenue-optimization technique that uses market segmentation to achieve strategic objectives such as increased profitability or higher market share. Price and revenue optimization has demonstrated repeatable results. It first came into wide use in the travel and hospitality industry in the 1980s. It enabled hotels and airlines to maximize returns from less flexible travelers such as people on business trips, while minimizing the unsold inventory by selling incremental seats on flights or hotel rooms at discounted prices to vacationers.

Pricing software enables organizations to establish a more intelligent process that replaces a single-price-for-all approach with methods based on a buyer’s willingness to pay. There are a range of techniques that organizations use depending on the nature of the business and how the organization sells its product, because what works for hotels doesn’t work for industrial wholesaling or retail banking. In B2B relationships, customers are segmented by the organization’s characteristics such as size, the importance of the seller’s product in the buyer’s business model and past business interactions. Many retailers use dynamic discounting, a method of gradual price reductions based on the difference between actual and estimated sales. Buyers are anonymous, so if merchandise is on the shelves longer than projected, it is by definition overpriced and the price is reduced by an algorithmic-determined amount. In most advanced economies, financial services organizations are governed by know your customer (KYC) rules. This data is useful in segmenting customers for setting interest rates on loans and savings deposits. The use of intelligent pricing enables executives to set a strategy and define the tactics that optimizes company-desired profitability and market share.

For companies that want to manage profitability to optimize revenue and margin, economic costing is necessary in setting prices because that cost defines the lower limit of acceptable prices. If a buyer is willing to pay X for a good or service but the real cost of that is greater than X, then in almost all cases that bid should be rejected. This approach is consistent with the use of loss leaders, because the loss leader is designed to be part of a profitable basket of items.

In handling profitability analytics, organizations—and the finance organization, in particular—typically face four challenges. Some or even most of the data they need is inaccessible, inaccurate and inconsistent. They may be using analytical systems that are too slow, too inflexible and too expensive to be practical. Or they are using desktop spreadsheets, which are error prone and time consuming for doing any sort of ongoing enterprise-wide analytics, sophisticated analytics or periodic reporting. And they may be using faulty measurement frameworks built around financial accounting constructs rather than operational or management accounting methods.

None of these should be showstoppers; rather, each can be a catalyst for much needed change in the department. For instance, data issues plague most finance processes including the close, management accounting, and external and internal financial reporting. Fixing data issues pays dividends all around the department. Technologies for more effective management of data, including those accessible to business users, have advanced considerably over the past decade. A second issue: slow, inflexible and expensive legacy analytical systems also keep FP&A for doing more sophisticated analytics that enable executives to make better decisions faster and more consistently. These can be replaced. As for measurement systems, activity-based costing or marginal cost analysis provide a better framework than statutory accounting for costs. And there are apps for that, too.

I recommend that every finance organization and specifically the FP&A group routinely measure customer, product and channel profitability using an economic costing method to do the analysis. This is most effective when done as part of a coordinated cross-functional effort. Within the sales organization, the sales operations team and/or a pricing group manages and reviews the pricing of products, services and contracts. Marketing creates campaigns and offers, which need to be tied to revenue and profitability objectives. And operations—whether it is manufacturing, services or fulfillment —must be involved to understand the nature of costs, constraints and other details.

Ideally, cross-functional initiatives are led by the CEO, whose involvement and commitment are necessary to mediate with authority the inevitable differences between conflicting objectives and constraints. If the initiative does not spontaneously come from the CEO, I suggest that the CFO should be a champion. This individual should make profit analytics a top three priority, and advocate the use of demand-based, intelligent pricing in the leadership team.

Profitability management is a software-enabled discipline for today’s rapidly changing market conditions. Sellers must be able to quickly adapt by having a full understanding of the true economic costs of products, the cost to serve customers and to operate channels. They must be able to make pricing decisions that enable them to successfully execute their go-to-market strategy. Profitability management is not simple, which is the reason it can be a source of sustainable competitive advantage.

It is common for writers to claim that business has never been more challenging than today. That may be true but it is important to recognize that business challenges never change. Organizations must offer customers appealing products or services, attract and retain the best talent, market and sell effectively, maintain financial control and so on. However, business environments do change and so do the tools available to those clever enough to use them to gain an advantage. Profitability management is just such a tool for our times.

Regards,

Rob Kugel