Profound changes are occurring across today’s corporate landscape. After years of record earnings, major U.S. banks find their future projected revenue stream flat due to increased government regulation. Conversely, energy companies and utilities are grappling with deregulation and transforming themselves into more competitive entities. Manufacturing and retail firms continue to face increased competition from Asian competitors. Now, more than at any time in recent history, U.S. companies need to understand the economics of their business model that drive the fundamental creation of profit.
To this end, many firms have developed robust models to determine the profitability of individual customers, either as in-house proprietary IT models or expensive off-the-shelf software programs, that have delivered less than the value promised and been difficult to develop and implement. However, with a pragmatic approach and the right team, profitability analysis can be executed effectively.
Most firms attempt to model profitability by developing Activity Based Costing (ABC) models to assign costs to individual clients or products. This technique, originally developed and refined at Harvard Business School in the 1980s, has fallen in and out of vogue over the last couple of decades. Unfortunately, the reality of implementing ABC models can be far more difficult than the academic theories sound when taught at business school. It is unfortunate that so many firms abandon their efforts.
What is often misunderstood in these initiatives is that, in addition to having a team well grounded in finance and cost accounting, successful implementation also requires strong organizational change management, project management, and interpersonal communications skills. In addition, the team should have an aptitude and fundamentally sound understanding of technology applications to drive effective automation of such an effort.
Profitability Analysis is truly one of the most cross-functional projects any organization can undertake, and despite the underlying financial analysis that goes into the modeling, the effort is very much an organization change management initiative and it is important the right individuals lead such an effort to ensure success.
Here are some key considerations the management team should consider when embarking on developing a more robust financial model to understand which customers, or products, drive profit:
• ABC is usually enabled as an IT tool, but it is not an IT project! Often operations managers are not adequately involved in the development of the financial models. From front-line managers, to the C-suite, operational managers must be involved in ABC modeling to make it work.
• Ensure the information is transparent! The finance team, IT organization, and consultants should not create a “black box” that is not clearly understood by the operational consumers of this information.
• The model will never be 100% accurate. This is not a realistic, or necessarily desirable, outcome. It is often said in this sort of modeling that it is better to be “Approximately right then precisely wrong!” The reality is not every cost center’s activities can be discretely measured and assigned to a product or client, generally because many cost centers spend time servicing clients, but that specific time is not recorded by any IT work flow system. It is best to find proxy measurements that best fit the situation for these cost centers and finish building out a basic model.
• Don’t model every cost center! One general rule out there is that if a cost center has less than 5 FTE’s, or $500K in annual spending, there is no appreciable gain in business performance by spending an inordinate amount of time modeling how to assign that expense to specific customer or product consumption.
• Automate to the extent possible by leveraging existing IT systems. Initial ABC modeling efforts are often abandoned by a business because they rely on too many manual processes to feed their models. The allocation of time spent on feeding a model by valuable FTE resources begins to outweigh the benefit of the information provided and a business decision is made that it is no longer worth the effort.
• GET GOING!! If left unchecked by the Project Manager, these sorts of projects suffer from “analysis paralysis”. Start with a small proof-of-concept model and build on the momentum. Don’t try to model an entire business unit right off the bat. Look at a particular location, or specific shared service center, such as IT or HR. Show some value from the project within the first 90 days to demonstrate value to the business that substantiates the effort on the project.
Understanding the customer or product profitability is vital for an enterprise to define how to orient their business. If a company lacks this sort of basic understanding of their business, how can they begin to ask themselves which customers they need to attract, which customers they may be better off without, and which internal transactional processes need to be improved to reduce costs?
To successfully execute such a project the executive team needs to ensure they have the right types of individuals, with the right skills and aptitude, to make it a successful project. In addition, the executive team and the project team, whether they are external consultants or internal project team members, should carefully consider the issues outlined above as they deploy such a project.