One of the ways in which management can boost the profits of their business, is to ensure that their strategy leverages key elements of the business model.
Identifying Profit Multipliers
The first step is to undertake sensitivity analysis of the Income Statement to identify potential profit multipliers. There are cost-effective software packages that can assist you to easily change one variable and examine the impact on bottom line profitability. In the absence of having a software package, it is possible to create an Excel Spreadsheet template in which you create a base case Income Statement that is populated with current figures. To be absolutely thorough, you should take each line item in turn and change each variable by one percent (1%). Using double entry bookkeeping practices, follow the impact of a one percent change on each variable upon profits. If a one percent change in a variable results in a far greater percentage change in the bottom line (profits), then you have identified a potential Profit Booster.
When making your one percent change, it is important to decide whether you are adding or deducting one percent. The table below will provide a guide on whether you should add or deduct one percent.
|
Variable |
Add 1% |
Deduct 1% |
| Sales/Revenue/Income:
Quantity sold Unit price |
. X X |
|
| Cost of Sales:
Purchases – unit price Closing inventories/stock Direct/variable costs |
. X |
. . X X |
| Operating expenses |
X |
Align Your Strategy with the Business Model
Once you have identified the variables that make the biggest impact on profits, review your strategy to ensure that you are capitalizing on the multipliers that can Boost your Profits.
The following case study illustrates the application of this approach. We were working with a wholesale hardware distributor that supplied all the major hardware retailers across the country. The Chief Executive believed that the investment in inventories was too high. The Senior Leadership Team (SLT) decided to reduce this investment in all of its Distribution Centers (DCs) across the country.
As prudent business people, they had undertaken an intensive analysis of their inventory holdings. They had turned all obsolete and slow moving stock into cash by selling these items off in a fire sale.
They had also undertaken a Pareto Analysis to highlight the twenty percent of their inventories that accounted for eighty percent of their sales. They were focusing on these slow moving stock keeping units (SKUs) i.e. the eighty percent.
There were some unintended consequences of this strategy.
- The cost of moving some of these items around the country to outlets that had higher unit sales of these items outweighed the benefits of the sale; and
- The level of discounting required to move some items frequently was at a price below cost; and
- Ultimately, they were unable to support some products as they no longer carried these spare parts. This impacted negatively upon their brand and total sales declined.
We undertook the analysis described above to identify Profit Boosters. We discovered that a one percent (1%) change in inventories created a three (3%) change in profits. A one percent (1%) change in price would likely result in a ten percent (10%) change in profits, provided that the quantity demanded was unaffected by the change in price.
We therefore examined the price elasticity of demand, which is a measure that shows the responsiveness of the quantity demanded of a good or service to a change in its price. If a one percent (1%) increase in price results in a fall in the quantity demanded of more than one percent, then we conclude that the item is price elastic. If a one percent (1%) increase in price does not impact the quantity demanded, we conclude that the item is price inelastic. Our research indicated that the ultimate consumer would not change their buying behavior if prices were increased by up to five percent.
Armed with this information, we presented what was considered a radical idea at that time. We suggested that the company test market the following strategy before rolling it out country-wide:
- Instead of focusing all of management’s efforts in reducing inventories, we recommended that the company do what was, at that time, considered to be counter intuitive. We proposed that the company buy back all unsold inventory in the retail pipeline.
- All inventories would be supplied on a consignment basis until sold, at which time, the company would invoice the customer
- The company would take full responsibility for merchandising product in store. This means that company staff would work in the retail store to ensure that shelves are always fully stocked, properly marked and priced and looking good
- Company representatives in store would all be fully trained to sell all products, trade customer up and cross-sell their products. This would result in a win-win outcome for the supplier, the retailer and the consumer. The supplier would create constant stock pressure and support all retail advertising with a ‘push’ strategy in store. The retailer would simplify its business, reduce costs, improve cash flow, maintain margins and improve customer loyalty. The consumer would be the recipient of better and more informed service, thereby increasing perceived value in exchange
- In this way, the company would better understand consumer needs and expectations and align the product mix in each store with local consumer demographics and psychographics.
- This knowledge would also assist the wholesaler with new product development and refreshing existing products.
- Being in store, company representatives would see and hear competitor activity, thereby improving competitive intelligence
As this was an innovative retail strategy, the wholesaler would derive all the benefits of first mover advantages in the industry.
In exchange for all of these benefits, the company would ask the retailer for a three percent increase in price to cover the increased cost of holding the inventories and the cost of having retail service assistants in store. We anticipated that the retailer would want to preserve its margins and would therefore mark up products by more than the three percent to maintain its profitability. We felt that this price increase to the consumer would be less that the threshold at which volumes demanded would decrease.
One of the objections that we felt that retailers may raise would be the fear of losing control of the customer. We pointed out that the retailer would still ‘own’ the customer as most retail sales were cash or credit card sales and the trade retained merchant accounts with the retailer. Therefore, the company would not be building a database of customers that they could communicate with directly.
The client rejected the strategy on the basis that it wasn’t industry conventional wisdom. They felt that, even in a test market, it would be too difficult to reverse the strategy.
In today’s retail environment, it has become common practice in some departmental stores to allow manufacturing brands to fully manage branded kiosks within their stores, thereby reaffirming that the strategy was sound but was ahead of its time for a conservative leadership team.
Identifying your Profit Boosters is likely to spurn new and different thinking that could reinvent your strategy and deliver a much healthier bottom line.
