Is there such a thing as Perfect Profitability?
The ultimate business problem – can a company truly attain perfect profitability; perfect volume, perfect price, perfect cost, and perfect mix? Is there such a state?
First, let’s focus on the word perfect. In this context perfect does not mean 100% as in one company should be able to attain 100% of market share. Instead, in this context it means that a company is achieving what they should be achieving based on their market position and customer value proposition. And that company is charging a price that is in equilibrium with the value curve for the given products and competitors. And that the costs to produce the product and serve the customer are minimized without sacrificing quality, customer service, or safety. And lastly that the mix of products that the company produces is optimal given capacity constraints and customer demand.
Some companies might argue that they are in fact perfect or nearly perfect, but the truth is that many companies have room for improvement, and the value of that improvement is substantial. Take pricing as an example. As experts from McKinsey & Co famously highlighted the value of pricing in their book The Price Advantage, a 1% improvement in price can create a 9% improvement in operating profit.
So if the monetary benefits of perfect profitability are real and present, why do so few companies (if any) achieve perfect profitability?
Let’s examine a few reasons:
1. Cross-functional Decision Making – Let’s face it, companies do not work well across functions. Most companies are structured into functional groups, not value streams, and profits are generated and measured in value streams. So coordinating any action, let alone improvements, requires collaboration which goes against the grain of the organization’s structural fabric. Better profitability decision making requires synchronization of various departments and taking action that may even conflict with their specific departmental goals but adds profitability overall.
2. Incentives – Profitability is not everyone’s goal. In fact, in many companies profitability is no one’s primary goal – which is odd since that is the primary purpose of a business. The CFO may be accountable, but they are typically not responsible. And what about Sales? They are typically measured on overall sales, not profitability, so they are not incented to reach the maximum price a customer is willing to pay. In the eyes of the salesperson, the effort required to squeeze out the extra 1-2% in price is simply not worth the investment. After all, they are only giving up their incentive on the extra 1-2% while minimizing the risk of the sale (by the way, this is why real estate professionals do not aim for the highest price when selling your house).
3. Focus – Perfect profitability requires a focused effort. This can be nearly impossible with companies that are in a constant state of flux due to market conditions, changing strategic initiatives, or just plain culture. Companies that try to achieve perfect profitability in an unstable environment find themselves in a carnival game of Whack a Mole. So the definition of perfect profitability can vary company to company and even between functional teams within one company.
So all is futile and we should just punt on this idea of perfect profitability? Not quite. There are 3 key steps that a company can take to start on this journey.
1. Focus – Understand and define what perfect profitability means to you. Each company has a different strategy, so the idea of perfect profitability should be defined within the context of that strategy. For example, if market share is critical to your industry segment, then focusing on perfect volume as your primary goal followed closely by perfect price may be the right formula for you.
2. Incentives – Create an incentive measurement system that rewards behavior that moves a company closer to perfect profitability. Once you have defined what perfect profitability means to you, your incentives structure should be designed to align with that definition. Sales people in general should be not solely incented on total sales dollars; there should typically be a margin percentage component as well. And goals should not be arbitrarily set; they should be set to what you have defined perfect volume, perfect price, perfect cost, or perfect mix to be. Arbitrary goals can create short-term benefits but cause long-term consequences (e.g. setting prices too high can achieve a short-term profit gain while driving away loyal customers).
3. Cross-functional Decision Making – Create a cross-functional committee designed to make informed profitability decisions in a collaborative manner. Functional boundaries prevent the sharing of information and decision making that affects the flow of profits across the organization. As an example, companies that have adopted an S&OP process, have benefitted from significant improvements in their supply chain from cross-functional decision making. A parallel profitability committee can be formed to integrate with S&OP teams or to operate in place of one.