In Search of Profits

One of the recurring themes during my week at HBS was understanding profitability.  At first glance, profitability seems like a seductively simple topic. After all, aren’t profits just sales minus costs? 

The issue, of course, is that getting a handle on costs is a non-trivial exercise.  For many organizations, the cost of goods sold (COGS) only represents the direct, physical assets used to manufacture products and ignores the indirect or overhead costs associated with the products.  This especially can become a problem with selling, general, and administrative (SG&A) expenses which organizations typically consider fixed.  In fact, in many situations these expenses are neither fixed nor variable but rather super variable; they increase at a faster rate than sales revenues.  As a result, costs are not adequately accounted for and calculations of profits are inaccurate.

To address this growing problem, some organizations have turned to sophisticated activity-based costing (ABC) techniques to get a more accurate picture of product or customer profitability.   Unfortunately, in practice ABC systems have proven to be unreliable or impractical because they rely on individuals’ subjective assessments of how they spend their own time and can require substantial overhead to administer.  A new approach called time-driven ABC attempts to address these limitations by turning the calculations around.  Rather than asking individuals to report on what they did, TDABC first identifies the different resources required to produce a good or service and then factors this by an estimate of time required to perform a specific activity.  Any loss of potential accuracy from averaging across multiple workers performing similar tasks is more than made up by the simplicity to administer. 

During the class, we went through a number of exercises to understand individual product, order (groups of products), and customer (groups of orders) profitability.  Associated case studies showed that our intuitive notions of profitability were often wrong; products or customers that we expected to make the most money off of were usually the least profitable.    Unlike the situation in sales volume in which 20% of the customers provide 80% of the sales, the most profitable 20% of customers usually generate between 150% and 300% of the total profits while the least profitable 10% of the customers lose between 50% and 200% of the total profits!  The bottom 10% are the customers that are most costly to serve; many times these are your largest customers in terms of sales volume. 

In my discussion group, we talked at length what to do with this bottom 10%.  While there is no cookie cutter answer, in general we agreed that we would likely raise prices for this group so that they either became more profitable or they stopped doing business with us.  A lessen we all can learn: fewer customers can lead to higher profits. 

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  1. Profitability Harvard style « AccMan - August 15, 2007

    […] Manage By Walking Around because the author has an enquiring mind. But when I read his write up on Profitability I was surprised that something I thought was well understood still exercises the minds of business […]

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