Profit Optimization: All management teams want to position their company to weather the ups and downs of the business cycle without compromising its ability to thrive. Optimizing profit targets is key to this goal. While all organizations generally put some effort into profit optimization initiatives, I have found that when these attempts fail, it is because they lack a strong framework for setting the right goals or a strategy for realizing their goals.
Creating this kind of framework is all the more important when economic trends are grim. A potential recession may challenge expected revenue growth and cash flows. Inflationary pressures push up wages, material costs, and operating costs and erode profitability unless they are quickly contained by price increases or other compensating levers. Higher interest rates further tighten the screws and negatively impact returns on invested capital, particularly for businesses with unsecured floating rate debt obligations.
Step 1: Define optimal profitability and set goals
As Yogi Berra said, “You have to be very careful when you don’t know where you’re going, because you might not get there. Once you untangle this advice, it applies to all strategic planning. In optimizing profit, it is important that management does not engage in initiatives that bring short-term improvements at the expense of long-term strategic goals.
I often see management teams setting goals without knowing the true potential of their business. Traditionally, you would analyze your historical data to estimate future profitability goals – but this can shortchange your organization. On its own, historical data cannot tell you everything about your business capabilities, especially when circumstances change or whether your company’s past performance is sustainable over the long term. If you only look at what you’ve done before, you might set a goal that falls far short of—or worse exceeds—what you can actually achieve.
Step 2: Identify levers to optimize profitability
With benchmarks and goals in place, management can move on to the next step in the strategy-making process: identifying the operating levers that will lead to the intended results, and then testing those goals.
From my experience with various clients, I know that it can be tempting for management to focus on reducing operating costs and implementing lean initiatives as a path to optimized profitability. Operating costs and efficiency are undoubtedly significant factors in any overall strategy. However, management does the organization a disservice if it overlooks the role that revenue and gross margins can play in optimizing profit, as there may be ample opportunity to improve the product portfolio, pricing strategy, or cost of sales. These improvements can have a significant impact on EBITDA margins.
Step 3: Identify and prioritize margin improvement initiatives
Once the largest areas of opportunity have been identified, the next step is to use sensitivity analysis to determine which of them pose the greatest risk to EBITDA margins and which offer the greatest potential improvement. This analysis allows management to begin developing a plan to close the gaps and expand margins. While ideally a company would focus on all areas of improvement at the same time, in reality this may not be possible. Prioritizing initiatives is critical to allocating resources to the most effective possible activities.
During this step, consider the following factors for each improvement opportunity:
- Degree of management control over the opportunity
- The time it will take to implement a change that has a significant impact on margins
- What will realistically be required to achieve the maximum potential improvement under the most likely scenario
- How significantly each metric affects margins
Step 4: Communicate and implement
With initiatives defined and prioritized, management must now communicate the action plan to the rest of the organization and begin implementation. This requires the same care and planning as what came before. Without the right communication strategy, resources and capabilities to support a successful outcome, even the most well-defined plans will be useless.
