categoryCost and Profitability Analysis

Achieving True Cost Transformation

Suppose your business is facing significant competition from traditional and non-traditional competitors. Demand for your company’s products and services is tepid and customers are deserting you. Revenues are in sharp decline and the impact is beginning to show in shrinking margins.

To increase revenues and alleviate shrinking margins you try to cross-sell and up-sell your products and services, but all your efforts are in vain. You ultimately decide to embark on a company-wide cost transformation initiative.

Do you cut back on equipment investments, reduce marketing and IT spend, sell some of your business assets, lower inventory levels, lay off certain employees, freeze salaries, shrink transactional administrative costs or eliminate all cosmetic travel and training?

Although the above cost reduction measures are all necessary, they are basically short-term wins which are difficult to sustain in the face of new technologies, changing customer expectations and increasing competition from new entrants and other disruptors.

Cutting costs for the sake of it

Many organizational cost transformation initiatives fail to deliver lasting gains because they are often implemented in isolation without the context of the broader strategy of the business. You need to understand that cost transformation is not simply a matter of cutting costs randomly.

Rather, gainful cost transformation is linked to strategy and drives the effective execution of that strategy. In my experience, I have realized that majority of cost initiatives are more inward focused and less outward focused.

It’s all about increasing the bottom line as opposed to making sure the business remains competitive. More backward-looking and less forward-looking.

Because cost management is misaligned with business strategy, there is little focus on generating capital to fund strategic growth initiatives or diverting resources from low performing business units or unviable markets towards higher value and return opportunities.

Partly to blame for this misalignment is lack of understanding of strategy by employees across the organization. As a result, employees are unable to distinguish necessary costs (essential to meet customer expectations and deliver the organization’s value proposition) from unnecessary costs.

That is why it is important for employees across the organization to have a clearer understanding of the strategy of the business, its objectives and how these will be achieved, including the costs.

The devil is in the detail

Given that there are necessary and unnecessary costs, implementing across the board cuts will only yield marginal gains. Ultimately, high performing business areas or markets end up badly impacted because of such mediocre management decisions.

Instead of channeling resources towards investments, projects and markets which matter, or customers who matter, lackluster business performance areas tend to receive the limited resources.

To obtain customer, product or channel profitability visibility and optimize costs, you need to understand the key drivers of each. Implementing activity-based costing principles and techniques can help you answer any cost transparency and visibility questions you might have.

For instance, basing cost reduction decisions on consolidated gross margin alone obscures the reality that your business is actually making losses on particular products, customers or in certain markets.

You therefore need to drill down and understand the costs-to-serve each customer, service line or product and their drivers. This will in turn help you explain why costs are unnecessarily higher in certain business areas and make informed decisions.

Thanks to advances in technologies, companies are now able to leverage advanced analytics to analyze customer, product, market and channel data and generate insights into costs and where savings opportunities exist.

Use it or you will lose it

This culture is prevalent in organizations that are yet to break free from the shackles of the traditional annual budgeting process. During the financial year, business unit managers underspend their budget allocations.

However, towards the end of the year, to avoid losing the unused budget allocation in the forthcoming year, they willy-nilly spend the funds resulting in unnecessary costs. These funds could have been deployed somewhere for profitable return.

Unfortunately, such scenarios do little to transform the cost structure of the business and transition to a value-based model.

To avoid the culture of “use it or you will lose it” spreading over, leaders need to foster a culture of accountability, performance reporting and continuous improvement.

Hence the need to align cost transformation initiatives with strategy. Cost reduction targets must clearly be defined, both at enterprise and business unit levels, then hold leaders accountable for achieving performance improvement goals.

It’s therefore imperative to educate employees on the future financial needs of the business. They need to understand the costs that really add value in your business, and those that don’t.

Cost transformation is not a one-time initiative. Instead, it is a continuous improvement approach for leaders seeking to transform the cost structure of their companies and deliver a sustainable business advantage.

This does not necessarily mean that leaders should entirely focus on cost reduction efforts. You need to maintain an appropriate balance between achieving cost reduction targets and supporting necessary innovation and process improvements that drive effective execution of strategy and the ultimate success of your business.

Prioritizing cost optimization initiatives with only short-term goals in mind can cause unanticipated problems.

The Role of Finance in Pricing Decisions

One of the key financial metrics constantly measured and monitored by the business is the level of profitability growth.

For any company, profit and positive cash flow, are both critical and with a company that does not initially have investors or financing, real and not paper profit may only be its capital. Without sufficient capital or the financial resources used to sustain and run a company, business failure is imminent.

The bottom line is that no business can survive for a significant amount of time without making a profit. That being the case, the measurement of a company’s profitability, both current and future, is critical in the evaluation of the company.

In an environment where competition is intense, customer loyalty is diminishing and business growth is not a guarantee, the scramble for the profit pie is far from over.

Faced with these mounting challenges, businesses embark on cost transformation initiatives to boost profit margins. Normally, the exercise starts by looking at the company’s Profit and Loss historical spend, analyze the cost drivers, justify the spending and then make the decision to wield the axe or not.

Sometimes an across the board approach is pursued whereby an equal percentage cut is applied to all business areas. The drawback of such approaches is that they only allow you to extract limited savings that are not sustainable in the long term.

Also, business areas that have future potential for growth and require continual attention and investment are sacrificed for short term gains.

In other cases, the focus is more on increasing revenues, either through new business development, growing the existing product line, up-selling or cross-selling. Provided there is demand for your new offerings and recurring costs are not significantly high, the results could be different.

However, there is another focus area, in my experience, I have noticed is often not granted adequate resources and effort despite its massive potential to grow both revenues and profitability.

Effective Pricing

Pricing has a substantial and immediate effect on company profitability and any significant price changes in either direction can have unexpected effects on the bottom line. Managing pricing is therefore a vitally important lever to increase profitability and generate funds for investment.

With margins increasingly getting squeezed due to costs escalations, using the wrong pricing model for your business increases the risk of losing money on some customers or contracts by applying the same pricing approach and margin across the board.

Although companies differ noticeably in their approach to price setting, the goal should always be to get the price right across all customers, channels, segments, products and service lines. The challenge today, especially for B2C businesses, is meeting the constantly evolving needs of consumers at a reasonable profit.

Consumers are increasingly demanding quality, immediate availability and superior after-sales service at a much lower cost than before. On the other hand, input costs are not declining. In such an environment, the effectiveness of traditional cost-based and competition-based pricing approaches is challenged.

Since these approaches are reactive in nature, perhaps the competition has raised prices or perhaps the COGS has increased, can you afford to raise prices without losing business to a competitor?

Finance and Sales & Marketing Collaboration

In a number of organizations, pricing decisions are the remit of sales personnel in the field. The absence of robust pricing processes in these organizations often result in sales personnel basing pricing decisions on gut feel.

Additionally, because of the pressure to bring in new deals and reach the sales quota, heavy discounting is widespread and chaotic.

Working hand in hand with sales and marketing teams, finance can help fix the broken system and bring transparency and discipline to pricing decisions.

  1. Clarity on customer sensitivity to price variations: With so many factors affecting a company’s profitability, it can be difficult to determine the best way to price your products and achieve the desired profit levels and customer loyalty. However, disciplined pricing execution is highly dependent on the specific products’ price sensitivity, or customers’ willingness to pay a different price for a product without affecting demand. Leveraging their commercial acumen and analytical strengths, finance personnel can help develop business rules and sophisticated tools that quantify customer price sensitiveness and willingness to pay and improve price levels.
  2. Document and implement new processes: In the absence of robust processes to ensure discipline in price setting and prize realization, the organizational consequences of not following pricing guidelines are too big to ignore. As process improvement specialists, finance can help put into practice processes and tools to document, monitor and communicate incentive systems, acceptable discount levels and price variances to sales and marketing teams and other decision makers. As a well-run business, you want to ensure that the price the company gets is a close as possible to the price the company wants. Thus, any price changes have to be justified and documented for approval.
  3. Define pricing boundaries: Companies usually use historical heuristics, such as cost information, to set prices. At the anniversary of each contract and during pricing review, very rare do most of them calculate the customers’ costs-to-serve. A standard increase is applied to previous pricing rates with the objective of getting a certain ROI or a certain markup on costs. This simplistic approach ignores the customer’s perceived value of the product as a critical factor for determining the final price. Finance can look to see whether or not the price points are too low, too many, or are at least profitable and value-based enough to be implemented. Through scenario planning practices, finance can run test-and-learn plans that help define pricing boundaries. New approaches are piloted, and prices are then optimized based on what works and what doesn’t.
  4. Drive change throughout the company: Evolving from pricing based on cost or competition (me too) to pricing based on customer value is a continuous learning process that requires a shift in culture. The process requires top management buy-in, sponsors and change agents who are committed to improving the organization’s pricing capabilities and overall system effectiveness. Finance business partners are well positioned to act as change agents, internalize value-based pricing and motivate the organizational changes required to support it. They are able to help colleagues understand the value reflected in prices. In turn, sales teams are empowered to address customer or client questions related to price variances and walk away from unprofitable deals.

Customer Experience and Customer Perceptions

It is vital for businesses to develop a deep understanding of their customers’ needs, perceptions of value for money and how any shifts in prices alters their willingness to pay. At the core of value-based pricing is having the ability to balance costs and the benefits attributed to your product or service.

One of the grave mistake you could make as a business is falsely assume that customers will immediately recognize and pay for your innovative and superior product. Today, rather than base their purchase decision solely on price, customers first want assurance that your product is the right one to fulfill their Jobs-to-be-done.

Instead of asking, “How can we achieve higher prices in spite of strong competition?” you need to start asking, “How can we generate additional customer value and increase customer willingness to pay, in spite of strong competition?”

Driving Profitability Through Enhanced Expense Management Policies

I don’t know of any private or publicly listed organization that is in business only to break-even. Among others, the main goal for these entities is to deliver a profitable return to the owners of the business. This desire to make profit with the least resources inherently makes cost management across the business a strategic imperative.

As strategic business partners, finance teams are suitably positioned to help their organizations manage costs and focus spending only on those activities and/or initiatives that enable business performance.

In my experience of working with diverse organizations and business leaders, I have come to the realization that quite a number of them lack a precise understanding of what “cost management” really involves. There is a common perception that managing costs is all about cutting costs or merely a matter of buying fewer goods and services. This is seldom true.

Cost management is not simply a euphemism for “cost cutting”. The discipline is about understanding the true cost drivers of the business and ensuring that a company acquires only goods and services that it needs to execute its strategic priorities at a known and managed cost. One of the areas I see organizations often struggle with is identifying those activities, processes and investments responsible for rising cost levels.

Because of this misunderstanding of the real cost drivers, many companies end up taking the obvious route of cost control: they reduce payroll-related expenses, cut direct costs and capital expenditures. Rarely do companies focus their attention on improving indirect expense management to drive savings and boost profitability with the same resources.

Inadequate Spending Information Acting as a Barrier Against Savings Delivery

In today’s digital-enabled business environment the ability of an organization to consolidate and analyze its indirect spending patterns is key to acquiring crucial insights essential to pursue better deals with vendors. Simply having information is not enough. What golden nuggets are you harvesting from this sea of information and you are able to use them as sources of leverage when dealing directly with suppliers?

Unfortunately, in my dealings with diverse finance teams, many of them are not analyzing their organization’s spending data and are therefore losing out on achieving substantial cost savings. One of the reasons often given by these teams on why they are not able to do so is lack of time and resources needed to analyze spending data and recognize the benefits. A significant amount of their time is spent on balancing the books and justifying the numbers.

I was surprised with the manner in which procurement reports are generated and delivered in one of the companies I recently worked with. Their procurement processes are still highly manual, all invoices are stored in lever arch files and there is no spend visibility across the organization. Each business function records its own spending and there is no overall aggregation of this spending information.

As a result of these highly manual processes, it is seemingly impossible for the finance manager to obtain a clearer picture of how much is being spent on each vendor and on what, say per month, quarter, half-yearly or yearly. Technology and e-procurement systems have evolved and because of these advancements CFOs and their organizations can gather this procurement information in an accessible, easy-to-use format and in real-time.

Lack of financial resources should therefore not be given as an excuse, there are now cheaper tools that an organization can invest in and achieve its spend analytics ambitions and these SaaS and/or cloud-based solutions do not require huge initial capital outlays.

When you have ready access to information and are able to analyze your company’s’ major spending categories, you will be able prioritize the use of your scarce time and resources, consolidate spending with selected vendors, negotiate better terms and realize substantial benefits.

Close Scrutiny of Discretionary Spending

Many at times I have heard people say in order to make money you have to spend money. As much as we would like to accept this statement in its entirety and pay attention to the advice, I think we should heed the advice with a pinch of salt. Not all spending is necessary. In addition to direct expenditures which are linked directly to the goods and services a company is producing or providing there will always be discretionary expenditures not tied to business performance.

However, uncontrolled spending simply for the sake of spending often leads to depleted margins and cash woes. Am I therefore advocating against discretionary spending? No. Responding to business opportunities often calls for flexibility and judgement. There are times where the organization has to leverage its cash position, take advantage of emerging opportunities to enhance its competitive position and improve productivity.

Close scrutiny of discretionary spending on things that are perhaps nice to have, but not enabling business performance is therefore critical. Finance business partners can help instill spending discipline and good judgement across the enterprise by educating employees on the How, What and Where of spending carefully as well as setting up spending policies to encourage productivity and enhanced performance.

Spending policies play a significant role in directing employee behaviour and generating useful information on what goods and services are purchased, how and where. For example, they help an organization drive savings through documenting and substantiating purchases, discouraging excessive acquisitions and prescribing exactly where and how employees may procure items.

Any off-policy spending patterns are quickly identified and addressed. However, in implementing these spending policies care must be taken that a right balance between control and latitude is struck. You want your employees to have a sense of empowerment and responsibility.

In other words, the company’s spending policies should not be viewed as punitive measures, but rather, allow employees the appropriate degree of flexibility, and nothing extra. This fosters compliance.

The Effectiveness of Any Spending Policy Rests on Its Widespread Adoption

Implementing the right spending policies is only part of the equation. In order for policies to be effective, employees must comply with them. In most cases you will realize that an organization has well-defined policies on spending, the finance executive is leading the pack garnering support for its enterprise-wide adoption and yet despite all his efforts the positive message falls on deaf ears.

Compliance often falls short and as a result the organization fails to achieve the intended benefits. As with almost every other aspect of everyday running of the business, senior management support is central to the success of any organizations’ spending policies. Senior management determines company culture and sets the tone for employee behaviour.

No matter how hard the finance executive tries to convert the positive message of disciplined spending, if the other senior leaders are failing to set a good example then we shouldn’t be surprised to see significant low levels of employee compliance.

Many organizations often suffer from a lack of consistent approach when implementing and upholding spending policies. For instance, you will find out that there is a clear prescription of the exact steps to follow when dealing with employee expense reimbursements. By default, the approach should be the same across the enterprise but then you start noticing some employees getting reimbursed for expenses that other employees are not.

Moreover, the senior manager approves the reimbursement of an expense without seeing the backing documentation even though the policy clearly specifies that a physical receipt or invoice must support the expense claim. This inconsistency sets a bad precedence resulting in finger-pointing as well as favoritism gestures. Rather, management should take the lead by enforcing policies uniformly throughout the employee hierarchy, and by demonstrating good compliance behaviour.

Furthermore, in order to ensure effective compliance, senior management should also communicate policies effectively as well as the business rationale and the more tangible benefits that the new spending policy would provide. Employees need to know what policies they will be held accountable for and why they are being held accountable.

I don’t believe there is an employee acting in their normal capacity who would join an organization just to do wrong. Employees, generally want to do the right thing and what a better way to support this ambition other than explaining to them all the nitty-gritty of the company’s spending policies.

Ideally, once the policies are enforced it is a good idea to regularly provide employees with feedback on their performance, the benefits that are being realized as a result of the policy changes and offer rewards where necessary. Following this approach bolsters the rationale for making the decisions and gives employees an interest in the company’s performance as well as a greater incentive to do well.

As finance executives step up to an expanded, more strategic role and seek to drive profitability across their organizations, it’s critical that they establish efficient and effective means to provide employees with the right tools, processes and structures they need to successfully perform their jobs without opening the door to spendthrift behaviour, poor controls, and irregular expenditures.

4 Tips for Improving Customer Profitability

Despite increased focus on customer centricity and putting customers at the core of the business, many organizations do not have an accurate understanding of which customers are profitable and which are unprofitable. With markets increasingly becoming competitive and consumer behaviours constantly shifting, investing in customer relationships is the key to long term sustained profitability.

Gone are the days of unrelenting customer loyalty. Today’s consumers are actively pursuing brands and providers who deeply understand their struggles for progress, why they make the choices they make and then create the right solutions and related set of experiences to ensure they solve their Jobs to Be Done. In other words, customers are looking for companies that are able to deliver unrivalled experience. Failure by the company to meet these expectations means the customer will simply choose to spend their money elsewhere.

Companies that are able to deliver this first class customer experience are better placed to acquire and retain more profitable customers, and increase the profitability of customers that are low or loss-making. Thus, as more companies increasingly focus on customer centricity, customer profitability analysis (CPA) should become a top priority for all businesses. CPA helps you identify which customers are profitable and which are unprofitable. Not only does CPA tell you the profitability status of each customer, done properly, it also helps you develop an understanding of why certain customers are more or less profitable than others.

Develop a Deeper Understanding of Your Customers

In the past accessing customer data was a big challenge. However, in today’s technologically driven and networked economy, detailed customer profiling is now possible. Thanks to advanced analytics, huge data sets can now easily be collected, stored and analysed to reveal strategic insights, and to a large degree, predict future customer behaviour. All this is achieved in real time.

Having a broader understanding of your customers empowers you to start offering products and services that communicate directly to various customer groups and deliver your brand promise. It also enables you to focus on one-to-one or personalized customer marketing as opposed to adopting a one-size-fits-all approach. Take time to understand what is it that your customers value about their relationship with your business and what are the experiences they are seeking in order to make progress.

So often businesses ignore the social, emotional and functional attributes of their product or service offerings and spend significant time on generics, resulting in frustrated customers and lost revenues. Customers are now hyper connected. Social media platforms are continuing to gain prominence as communication channels for customers to discuss brands, ask questions or raise issues and complaints. Millions of these voices should not be ignored at any one time as doing so leads to higher churn rates. Every social conversation is a real-time reflection of your brand promise and potential.

When companies engage and respond to customer service requests over social media, those customers end up spending more with the company and are also most likely to recommend the brand to colleagues. Do you know what customers are saying about your products and services and how to change the conversation if you need to?

Developing a deeper understanding of your customers means moving beyond the basics of income, age, gender, race or geographical location. Take a comprehensive and holistic view of your customers. Fusing different data sources, structured and structured will help you unlock key customer insights and differentiate your company from competition. Today, we have more data about customers, that is growing increasingly complex and dynamic. Gathering data is not the main problem. The real challenge is transforming information into insights that we can leverage to provide customers with a superior experience.

Know The Costs-to-Serve Component of Your Business

The core idea behind customer profitability analysis is that companies can improve their profitability and reduce their operating costs by being more customer focused. Emphasis should not be on acquiring a large number of customers, rather, on acquiring high-value, long-term customer relationships. Quality versus Quantity. Not all customers are profitable. On the face of it, they might all look profitable but when we dig deeper to assess their worth, you will be surprised to find out that a handful of them are margin leakers.

Knowing which customers are costing your business more to serve in comparison to the revenues they generate helps you channel focus and resources on this group in order to try and convert them into profitable buyers. When it comes to measuring customer profitability levels, using aggregate measures of profitability, such as gross margin, is misleading. These measures ignore the nuances of serving particular customers, segments or other populations of interest. One other common practice which is also misleading involves applying a flat cost-to-serve percentage to each transaction’s gross margin in order to calculate the transaction’s profitability.

Companies should analyse the profitability on a transaction-by-transaction basis and examining each transaction’s profitability based on its pocket margin – the actual profit earned after deducting all the costs related to a transaction. It is no secret that the majority of customers are after a superior product or service at the lowest price possible. Although at times it is possible to grant them concessions, long-term this is not sustainable.

When making pricing decisions, it is important to consider all of the things you are giving away that add value to the customer, and don’t forget they shrink your pocket margin and take money from your pocket. There is always that group of customers that is difficult to serve, constantly nagging you and making unreasonable requests. Because the majority of businesses are only interested in boosting top-line revenues and want to preserve the relationship, they are repeatedly giving in to these unreasonable demands.

We have to try by all means not to set a precedence for our customers and make them believe that they can get away with anything. There are times when concessions make sense, and other times a very bad decision.

By clarifying the impact of customer requests on individual cost-to-serve elements, a customer profitability analysis can help your company avoid leaking pocket margins through such slip-ups. At the same time, it gives you an opportunity to educate and empower your employees to negotiate more profitable prices and terms of service. ABC data can be used to calculate the overall profitability of serving a customer with a product.

A detailed breakdown of costs-to-serve can help you identify opportunities to improve profits by altering buying behaviour in ways that are relatively unimportant to the customer, but drive large cost-to-serve savings for you. By examining customers’ historical transaction details, a company can determine which products are likely to drive profitable add-on-sales. Up-selling and cross-selling opportunities are far more likely when the customers are happy.

Evolve Existing Customer Relationship Management (CRM) Systems

Digital transformation is a journey that’s well underway for many companies, and the connected customer is at the heart of it. It is no longer a case of whether a company should embrace digital, but rather, how soon. IoT and Industry 4.0 technologies are reshaping business models for the better, enabling companies across all industries to boost business performance and consistently deliver unique shopping experiences across multiple channels.

As companies adopt these new technologies, it is critical to drive data integration across the business and ensure that existing systems are capable of communicating flawlessly with other software. This will further enhance your abilities to collect and analyse data, and gain strategic customer insights at a very detailed level.

It is also important to acknowledge that the ultimate goal of CPA may not, in some circumstances, mean selling a product or service at a higher price, but providing a pleasant customer experience. Greater customer service also has a commercial value, even if it doesn’t deliver an immediate commercial benefit. Thanks to new technologies, companies are now able to discover new insights from previously unimaginable sources. Notable examples are speech and facial recognition applications. Through these applications, companies are now able get a better view of their customers, identify irritated or unhappy customers and stem some troubling trends way before they become uncontainable.

No doubt advances in computing power are presenting new strategic performance improvement opportunities for the business. However, care must be taken that the company does not end up investing in unnecessary systems. It is easier for the company to jump on the investment band wagon without first clearly answering why. Successfully and consistently identifying what information is the most relevant and generates the most value is key to selecting the right tool. Technology is an enabler of higher performance.

Transforming Customer Profitability is an Evolving Journey

For the business to obtain the greatest commercial benefit from CPA, there is need to transform not only the company’s management systems, but also the company’s attitude towards its customers. Customer experience is significantly differentiating leaders from laggards. How you engage with customers before, during, and after a sale will dictate future success. Additionally, CPA must be aligned and implemented together with the strategy of the business. If there is a divide between CPA’s stated goals within the business and the way this is actually delivered to the customer, the whole process will succumb to its knees.

Also important to note is that customer profitability analysis is an organization-wide exercise, and not an isolated exercise embraced by one department or segment only as this will not deliver the required levels of cost reduction and profit increases. However, due to resource constraints, you can start small, focusing first on a portion of revenues or a single product line, business unit or geography, and then expand the effort as resources allow. In the long run, these pilot projects can act as proof of concept and also generate profit increases that can be used to fund further improvements. It is better to start small than do nothing at all.

Customer profitability analysis gives a company a clear view of how much revenue each customer generates (what they buy and how they buy), how much it costs the company to generate that revenue, and, most importantly, when and why these costs are incurred. This information is then used to guide efforts to transform the company’s less profitable relationships into improved profitable buyers. Firing customers should be your last resort after you have exhausted all reasonable efforts.

3 Ways Finance Can Help Improve Operating Margins

One of the challenges facing today’s finance executives is improving operating margins for the business. Top-line growth is very slow, inflationary pressures are causing higher input costs, and customers are pushing for innovative new products and services, albeit at discounted prices. All these factors, among others, are significantly squeezing company margins left, right and centre.

Uncertainty is the norm today, rendering tried and tested ways of creating value unfit for purpose. Thus, finance executives and their teams have to come up with new innovative and agile ways of capturing value and striving in this environment, while at the same time keeping costs down. Look no further than the number of profit warnings, earnings miss and business closure announcements by companies of all types and sizes. This just shows how the pressures on margins are considerably increasing, and also not expected to abate anytime soon.

When it comes to improving operating margins, many finance executives normally make one of these common mistakes. Implement across the board cost-cutting initiatives (mostly focused on reducing employment costs), raise products/services prices, or offer steep pricing discounts with the hope that the discounting will boost revenues and translate into higher operating margins. The problem with these approaches is that they fail to take into consideration the value-add to the customer.

So what must finance do?

Think and Act Differently

Most of the time the finance executive’s focus is on improving specific elements of the Income Statement, instead of the entire business. This in turn results in the finance organization embarking on one-off cost reduction initiatives, that fail to differentiate and understand the difference between good and bad cost.

Instead of focusing on cost reduction, heavy discounting and price increases, the CFO and the team must apply innovative, non-traditional thinking to margin management. They need to have a deeper understanding of the forces (both internal and external) driving the business margins. Many finance executives are aware of the factors influencing their margins. But, do they really know the significant drivers at granular levels for each product, channel, geography, segment, market, or business unit?

Thinking differently and making use of ABC/M, Customer Life-cycle Value and Customer/Product Profitability Analysis techniques can help CFOs understand their organization’s costs and their drivers. It also helps them to think beyond historical top-line focus and current constraints, and focus on doing the right things. For example, the CFO will be able to ask and answer the following questions:

  • What does our customers value most?
  • Is our current value proposition delivering customer value?
  • Do we need to change our current business operating model?
  • Should we sell all the under-performing assets or not?
  • Should we exit all the under-performing businesses, brands, markets or channels?

In order to improve operating margins, it is critical that executives consistently apply margin management to the entire business. You need to manage margin the end to end processes of the entire value chain, and find a more integrated way of driving overall results as opposed to one element of the income statement or business. This helps eliminate waste and also leads to more transparent and informed decision making.

Make Insight-Driven Decisions

Although information systems have improved significantly, many organizations are still struggling to benefit from their use. For instance, there is an organization class that is still reliant on primitive systems that are no longer fit for purpose in today’s data driven-economy. Then there is another class of organizations who have implemented modern technologies to enhance decision making but are struggling to integrate these with existing systems or have experienced dismal implementations with far-reaching consequences.

The modern finance organization must leverage data and analytics to inform margin decision-making. For instance, CFOs can make use of advanced predictive modelling and simulation tools to identify drivers of margin, calculate margins under different scenarios and evaluate ways of improving the margins.

Care must be taken that you do not embark on a data-hoarding spree without first understanding why you need that specific data. You need to make sure that you are collecting the right data to analyse and extract meaning from, otherwise you will end up wasting your time, energy and resources analyzing wrong data and generating ineffective insights. Information is only as valuable as the decisions it drives.

Wrong data collection often results in ineffective analysis and generation of misleading insights which ultimately leads to slow and ineffective decision making. This also causes the business to react slowly to new opportunities and threats. Instead of being proactive, overall decision-making is mostly reactive.

When margin decisions are made based on insights, more emphasis is placed on adding value to the customer and not on quick fixes such as slashing more costs. You can cut costs only up to a certain extent, long-term this is not sustainable. Hence the need to find alternative ways of boosting margins. Evidenced-based decision making also enables executives to develop a more detailed understanding of the full set of profitability drivers for the company.

Cultivate a Margin-Focused Culture

Delivering improved margins also requires the organization to develop a common understanding of the meaning of margin management and why this is crucial.  This is necessary to promote accountability, drive the right behaviours across the organization and ensure that margin optimization remains a key priority.

Successful fostering of this culture depends on senior management buy-in and involvement. If the drive is coming from the very top, it becomes easier to embed the culture into the business and make margin improvement an everyday part of the decision making processes. Senior executives have to therefore show a commitment to margin improvement otherwise the middle and lower level employees will also not be committed.

CFOs are better placed to drive this culture because of their constant engagement with the business – Sales, Marketing, Operations, R&D etc. By collaboratively working with other business units, finance executives can provide them with the information and the tools they need to make decisions that support profitability goals. They can also help put in place metrics that are not focused on volume alone but also drive the right behaviours and stimulate growth.

Furthermore, CFOs have to ensure that they are consistently reporting and reviewing margin performance across all brands, product categories, channels, segments and markets on a monthly basis. This will enable margin management to get embedded in the fabric of the business, and also be fully integrated with the broader strategy of the business.

Improving operating margins is not the responsibility of the finance organization only. It should be everyone’s concern. However, finance must lead the conversation. The CFO must ensure that the right operating model and capabilities have been developed to identify areas of margin leakage and define improvement actions.

I welcome your thoughts and comments.

5 Ways Finance Can Help Improve Company Profitability

Businesses in various industrial sectors are undergoing a fundamental transformation as a result of the effects of globalization, advancement in new technologies and increasing digitalization.  Apart from presenting a wealth of opportunities to help the organization soar to greater heights, these changes are also presenting a variety of challenges on the business model.

They are altering customer behaviours, placing increased pressure on existing markets and impacting financial performance.  In these trying times, the finance function is being called upon to help steer the organization in the right direction and improve profitability.

Popularly known as bean counters, accountants are now required to support business growth initiatives and help grow the beans within their organizations. The modern finance function has evolved from being a “just numbers” back-office function to a “strategic partnering” front-office role providing deeper insights and a clear direction for translating the numbers into effective actions for those operating on the front lines of the business.

Whereas in the past the finance professional spent his day behind the scenes, glued to his computer, producing and reporting the numbers, today’s finance professional is involved in the business interacting with the other organizational functions and helping drive business performance. There is a joke about an accountant without a spreadsheet being described as “lost”. In the past, this could have been true, but not today. The bean grower of today is a strategist, a motivator, a leader, a team player, a change agent, completely understands the drivers of business performance and drives improvements in respect of new revenue and value-producing opportunities.

It is no secret that the finance function is the custodian of the business profit and loss. In times of economic downturn when cost control is critical, the finance professional is called upon to help identify areas where the organization can scale back in order to improve overall profitability. In good times, finance helps senior management identify new opportunities (new markets, new products, potential acquisition targets, new services etc.) that need exploiting. Disrupt or be disrupted is the mantra in today’s ever-changing business environment. The business has to evolve with times.

The challenge on the finance function is to deliver more with less. This has led to many organizations to embark on ad-hoc cost-cutting programs hoping to improve the bottom-line. Unfortunately, cost control alone is not sufficient or effective enough to enable the organization realize the targeted gains. You can only cut costs up to a certain level. This is because each cost initiative reaches a point of diminishing return, after which, the company has to explore new ways of improving profitability. In order to grow its influence on company profitability, the finance function must:

  1. Understand the Drivers of Business Performance.  To be effective bean growers, accountants need to move beyond numbers and get an understanding of the company’s product s and services and how they affect the profitability of the business. This means finance teams lifting their heads up from their financial reports and obtaining a better view of the business itself. Instead of focusing only on where the business has previously failed, finance should provide strategic insights, competitive intelligence and analysis that enable effective decision-making by the senior management team. For example, finance should be able to provide data, metrics and analysis that helps transfer the function’s own understanding of the drivers of profitability to others throughout the organization, in order to ensure that profitability develops into a basis for action.
  2. Help Identify New Pathways Toward Profitability. When it comes to profitability improvement initiatives, many at times the focus is on the bottom-line. As mentioned earlier on, eliminating fat from the bottom line works up to a certain extent. Cost reduction is a short-term fix but not sustainable in the long-term, especially if the company is looking to grow. Management become misguided and believe that by laying-off people to contain salary costs or postponing capital investments they are placing the organization in a better competitive position. The opposite is true.  In fact, cost cutting by itself is counterproductive as it can lead to inefficiencies, missed opportunities and higher operational costs. There is nothing wrong in getting the business lean, but getting lean has to be linked to the business strategy, done the right way, at the right time and for the right reasons. Attention should also be focused on the revenue side of the business, for example, diversifying the business, internally growing existing business units, making additional productivity improvement, improving existing product or service offerings and making major business purchases.
  3. Invest in Modern Technologies. As the amount of data generated continues to grow, an enormous demand is being placed on finance to make meaning of this data, identify trends and develop the most effective responses that will help protect and improve company margins. Finance must know what information will have the greatest impact on profitability since having the right information is at the core of improving company profitability. Equally important is placing this information in the right hands. Relying on spreadsheets alone will not cut it. Finance must invest and make use of modern Business Intelligence and Analytics technologies in order to be able to identify accurate, reliable and relevant information and place it in the hands of the right people at the right times. These modern technologies help transform finance into a more flexible, responsive and forward-looking function. The modern finance function must have the ability to use technology to gain a more detailed understanding of the metrics underlying the company’s profitability.
  4. Develop Effective Pricing Capabilities. The sales organization is normally rewarded on revenue made and this sometimes results in the sales team being interested only in closing the deal at the expense of profitability. Not all customers are equally profitable to the organization; therefore sales should be tailored to optimize profitability. Getting the pricing wrong has negative consequences on the overall profitability of the company. Finance need to have an advanced understanding of the company’s different customer and product portfolios. By performing customer profitability analysis and product profitability analysis, finance will be able to understand the customer costs-to-serve and use these costs to segment customers, fine-tune pricing and manage profitability by helping direct efforts towards growing profitable product and customer combinations. Sales personnel can then use this cost-to-serve in negotiations as well as forward-looking analyses to drive effective decision-making.
  5. Collaborate With the Rest of the Organization. Although finance plays a central role, maintaining and improving company profitability is a team effort – it should be everyone’s concern. It is imperative that finance professionals work directly with their colleagues outside of finance (Sales, Marketing, Operations and R&D.) and develop a list of actionable items which impact profitability. For example, working more closely with the sales organization will ensure that sales personnel have all the information and tools they require to make decisions that support profitability goals, otherwise they will be ill-equipped to make the best decisions. Getting the buy-in and commitment of the C-Suite is also critical since the C-Suite is involved in setting the direction of the company. The C-Suite’s involvement will in turn lead to the establishment of a common goal and set of metrics shared with the front lines of the business through synergies with their finance teams. Remember Individuals don’t win, teams do.

If the organization is to succeed in maintaining and improving its margins, finance’s involvement is important. Finance helps make meaningful and measurable profitability improvements.  Look at the bigger picture and beyond quick fixes such as rapid cost reductions. Develop a more detailed understanding of the full set of your business’s profitability drivers and take full advantage of new technologies capabilities to uncover the organization’s key profitability levers and challenges.

Differentiating Your Company’s Products or Services

Have you ever wondered why your customers keep on buying your products or requesting your services? Why they are willing to pay more for some of the products and services and less for the others? Could it because you are the only supplier in the area? If so, suppose a new company in the same line of business as you opens up a shop in the area, would your existing customers still continue to buy from you or they would defect?

There are various reasons why your customers keep on coming back to do business with you but one of the most significant one is driven by the value that you are offering them. Value is the core driving force underlying every business decision.

Although managers talk of value when determining pricing strategies, unfortunately, very few understand the true meaning of value, what it is, why it is so important, how it should be communicated and its critical role in pricing products and services.

To many of us, value means different things. As a test, ask your colleagues what it is that they refer to when they talk of value? Chances are high that you will hear different definitions. For example:

Some people equate value to expectations. To them, value is getting more than what they paid for, be it for an item or service delivery. In today’s information and social media age, perception alone is driving purchases.

Prior acquiring certain products or services, customers are communicating with each other on various platforms about the organization’s product and service offerings. By the time the customer makes a purchase, he or she in his or her mind has already built up expectations on what the offering will be able to actually deliver.

Only at a later stage after completing the transaction is the customer able to reflect and conclude that his or her expectations have been met.

Other people view value as a fair transaction. They look at the limited resources at their disposal and how best they can use them to meet their expectations. When purchasing an item, a lot of sacrifice has to happen.

One has to set aside time to search for the right item and choose from among options, evaluate the cost of money to purchase, the price itself and any associated psychological risk factors.

This sacrifice goes beyond looking at the monetary costs and also reflects on the time and efforts invested in seeking out the good in question.

In this instance, value is therefore viewed as the worth of the item purchased at least being equal to and certainly not less than the sum of the sacrifices made in acquiring it.

While others view value as expectations and fair transactions, others see value as an improvement of the current situation. Customers are looking for investments that are capable of improving their lives significantly.

Likewise, business managers are not keen on throwing money and resources at investments that will deliver a poor return and put the business in dire situations. Instead, they are looking for investments that enhance the business’s competitive advantage.

If any investment derives a return that surpasses expectations and genuinely improves the current situation, then value is said to have been delivered.

The challenge on business managers is to look beyond pricing and make sure that their products and services are delivering value to the customer or to the end-user consumer. Making pricing decisions based on cost and competitors’ prices alone will not cut it through in today’s business environment.

Customers possess the buying power and can easily defect to new suppliers if they are not happy with the current offering. Businesses therefore need to keep on reinventing themselves, re-examine the reality of the value they are offering to their customers and find ways to enhance the value they deliver.

Focusing on value helps business managers to understand the actual needs of its customers and find unique and differentiated ways of meeting those needs effectively and efficiently. When we talk about differentiation, it is not just about doing something different. It is about doing something different in a way that really matters to your customer and not just offering price cuts.

So many at times, when confronted with a customer challenge on price, the sales response is often to discount which often leads to early product commoditization. Of course, your product may be heading toward commoditization.

If this is the case, a thorough assessment and evaluation of the product and its relevance in the market is necessary. This will help you craft a strategy to reposition the product in the mind of your customers and prolong its lifespan.

Focusing too much on price prevents useful discussion of the real value of the offer. As a result, the buyer fails to distinguish the merit of what he or she has acquired and fails to gain, through lack of awareness, the full benefits from the products and services purchased. You need to challenge any claim that your product or service is just like everyone else’s.

How are your products or services positively changing the customer’s overall product or service experience? Communicating your differentiated solution in a clear, compelling and persuasive manner is vital to persuading the customer do business with you.

Differentiating the organization’s total customer offer from competition means that this difference delivers real value that the customer can identify, understand, acknowledge and be willing to invest in.

Unfortunately, this is not the case for many businesses. What these organizations are referring to differentiation are merely differences in specification and nothing more. There are no critical differences between their offering and those of the competitors.

For instance, many are making changes that are resulting in easier production of the product or easier delivery of the service just because they have the technology or know-how to do so but not a differentiation from the customer’s perspective. What impact is the change you are making on your product or service having on the customer’s business, in terms of both economic and emotional considerations?

In today’s copy-cat environment, it is easier for competitors to emulate your products and services and surprise you. Despite this, many organizations are still of the assumption that their differentiation will make the competition irrelevant.

Never underestimate your competitors’ abilities to shock you. You need to find unique ways of influencing the relative value the customer perceives, make the customer choose your product and service and remain with you.

How good are you when it comes to listening and fully understanding the customer’s context, value-adding processes and pain and pleasure points? Are you able to consolidate this information and create a product or service that offers real differential advantage from that customer’s perspectives?

Gone are the days of pushing products and services to the market. To do well, the business has to be a good listener of its customers. You need to possess intelligent consumer and product insights that are capable of leading you to new ways of differentiation.

You can differentiate your service by ensuring that your customers receive consistently great service. Consistency is key to having dependable and reliable customers.

Convenience and customization are also key to successful differentiation. By improving the convenience to your customers of using your product or service through using methods that are difficult for your competitors to imitate, you may be able to lock them in.

With regards to customization, you need to deeply understand your customer’s value adding processes or production operations. Having this deep understanding will enable you to identify where your company’s unique skills can be applied for the benefit of both the client and the service provider.

By fully understanding the real needs and motivations of your customers and timely responding to them, you can differentiate your total customer offer and reap great benefits.

Although there are various ways the organization can choose to differentiate itself from competition, regardless of how it decides to do so, learning and understanding as much possible about the customer, her company and market is vital.

Where are the sources of pain and problems he or she is experiencing that no one else seems to be addressing? As a business, how can we leverage our unique capabilities, contacts, technologies or other resources to address the customer’s problems in a way that is difficult for our competitors to copy but at the same time make it easy for the customer to buy and remain with us?

You need to deeply know and understand your customer in order to build a powerful, persuasive and compelling value proposition. In this day and age of plenty information, you can never know too much about your customer.

Every single piece of information you collect goes a long way in helping you understand your customer’s business, context, strategy or desires. Value is different for every customer and even for the same customer under different circumstances. This value comes from knowing all the critical details about your customer.

Learn everything about their value drivers. In addition to understanding your customer, know your differentiation – how and why you are different from your competitors. This will help you identify your competitive advantages and disadvantages, develop effective business and pricing strategies and enhance customer value.

If you are unable to justify totally the value-adding elements of your product or service proposition, your total customer offer is highly likely to be rejected by your target market.

Not All Customers Are Profitable And Worth Keeping

Not all customers are the same. Some customers are profitable and others less profitable depending on the behaviour they exhibit. Some people believe that the customer is always right and should therefore be satisfied at all cost. I tend to differ on this notion. Although customer satisfaction is crucial, the organization’s long-term goal is to increase customer and corporate profitability.

Achieving this goal requires management to strike a balance between managing the level of customer service to earn customer satisfaction and the impact this will have on shareholder wealth. The best solution is to increase customer satisfaction profitably.

Some customers, suppliers and trading partners are extremely high-maintenance. Unlike customers who place standard orders with no fuss, high-maintenance customers demand nonstandard everything. They are always asking for that special treatment.

For example, they make unwarranted delivery changes and require more after-sale services. If that is not enough, you always hear from them and in most cases to inquire about and speed up their order, or return or exchange their goods. If you add up all these costs-to-serve plus the costs of the products and base service lines you will be surprised to discover the magnitude of the erosion happening to your bottom line.

Knowing who your troublesome suppliers and customers are and also how much they are eroding the organization’s profit margins is critical for effective resource allocation and decision making.

What kinds of customers are loyal and profitable? Of your existing customer profile, which customers are only marginally profitable or, worse yet, losing you money? Does the customer’s sales volume justify the discounts provided to that customer?

Using Activity Based Costing/Management (ABC/M) techniques helps managers and employees find solutions to these questions and take corrective actions. Through ABC/M analysis, managers and employees will be able to trace, group and reassign costs based on the cause-and-effect demands generated by customers and their orders.

With better cost data at its disposal, the organization will be able to decide whether to push for volume or for margin with a specific customer, to alter its product and service offering to improve profitability or to assess whether benefits can be realized from changing current strategies by influencing its customers to alter their behaviour and buy differently and more profitably.

This in turn enables the organization to become more competitive because it knows its sources of profit as well as understand its cost structure.

The whole idea of carrying out the organization’s customer and channel profitability analysis is to identify the less-profitable customers and suppliers. Having identified these troublesome suppliers and customers, then what? Should you immediately terminate your relationship with these customers? Should you continue business as usual?

What about the already profitable customers? Must you streamline your delivery processes to reduce the costs-to-serve? With the facts, unprofitable customers can be migrated to higher profitability through managing service costs, introducing new products and service lines, offering discounts to gain more volume with low cost-to-serve customer, reducing their services, renegotiating prices or shifting their purchase mix to richer and higher-margin products.

Remember customers with high sales volume are not necessarily highly profitable. Customers tend to cluster. Medium-volume customers can be much more profitable than large-volume customers. Each customer’s profitability level depends on whether the net revenues are sufficient to recover the customer-specific costs-to-serve.

It is therefore important to know the types of customers that cluster in the various profit or loss zones as this can be valuable in determining what actions to take.

Furnished with better cost data, the organization can protect its most profitable customers from competitors. Because so few customers account for a larger portion of the organization’s profit, management must focus on retaining these profitable customers and derive value from their loyalty.

For those customers who drain resources and time, yet provide negative financial return and are concluded impractical to achieve profitability with them, they should be terminated.

The Role of Finance in Driving Sales Effectiveness

These days customers are more equipped with more information about the company’s products and services before they have even talked to the salespeople. Unfortunately, in most organizations, the sales function normally lacks high-quality data to drive sales effectiveness. For example, sales managers lack data to help align sales incentives, overcome price pressures and become a strong competitor in the market.

In these organizations, finance can play a critical role in delivering the information required to maximize sales productivity. In today’s economy of big data, the difference between success and failure more than ever lies in the quality of the data that finance shares with the organization’s salespeople.

Taking advantage of its analytical skills, the finance function can assist salespeople obtain the most relevant information about the company’s customers which ultimately helps transform the selling process and cultivate new relationships with the right customers. For any organization, sales costs are a major component of the expenses hence the importance of managing sales processes and improving sales performance. It is therefore imperative that you improve the way your company gathers and uses sales activity data in your planning, budgeting and forecasting processes. How do you rank the quality, timeliness, accuracy, transparency and completeness of the sales information used to forecast top-line revenue?

The quality of sales data at your disposal determines the usefulness of that particular data and your company’s ability to plan. In a world where technology is constantly evolving and aiding successful decision-making, to maximize sales force effectiveness, company’s should invest in analytical and modeling techniques in order to find out what changes would bring the best improvements in outcomes. This also includes improving management’s ability to use sales reporting tools such as dashboards. Getting hold of high-quality data for revenue forecasts requires you to match sales resources to changing opportunities and business objectives. This will help you retain customers from the jaws of aggressive competitors.

By gathering and integrating timely information about the company and its industry, salespeople will be able to gain insights about changes in customer behaviour which in turn leads to smarter pitches, shortened sales cycles and opening up of new opportunities.  Data that reliably reveals valuable selling processes and practices as well as patterns in customers’ buying habits is effective for improving sales force effectiveness.

As market competition continues to intensify, managers must improve the effectiveness of their salespeople as quickly as possible to avoid losing market share to rivals. Improving sales performance involves improving existing sales methods and processes, better training, better hiring, better sales management and making use of refined selling behaviours such as cross selling, bundled selling, targeted discounting and focusing on sales profitability.

In many organizations, salespeople are regarded as catalysts for growth and profitability. For salespeople to successfully fulfill their role, they need high-quality data and analysis. Thus sales must partner with finance in order to gain better insights necessary for effective decision-making. Instead of just reporting on the periodic sales figures, finance can educate salespeople on data gathering and analysis and provide them the relevant information so that they become better informed prior engaging current and prospective customers. Improving collaboration among finance, operations, sales and marketing and human resources enables the company to reach its stated objectives.

As the guardians of the company’s finance data, the finance function is in a better position to supply salespeople with the information they need to take a more strategic and data-driven approach to winning over customers. Finance is able to provide more analysis, more insights and more recommendations so that people are aligned with what drives the business forward. Thus with quicker and better information, as well as accurate forecasts and targets, salespeople are empowered to make more informed decisions about which customers to target and interact with.

To successfully deliver on their business partnering role, finance people should move beyond their isolated number crunching and routine transaction processing roles and partner more with other functions of the organization. Finance must become more proactive with data. More than projecting into the future, finance could use the information in the present to improve market and competitor insights and build better selling tools. Making data-driven decisions helps managers deliver more customer value with less, outperform rivals, target the right profitable customers, design the right value proposition and create value for the company. The key for finance is therefore to provide better information that is actionable to improve sales.

If salespeople are lacking in high-quality data about their company’s costs and price competition, they can and do end up working in complete opposition to management’s goals. Selling is not about selling products that are considered legacy products but no longer support the company’s strategy. Instead, selling is about selling products that are targeted to grow top line revenues. Salespeople should therefore not be encouraged to close deals that weaken the bottom line. Pricing controls should be implemented to ensure minimum levels of profitability while remaining sensitive to market competition. Find more profitable customers and avoid negative margin deals.

Furthermore, finance can also help educate sales managers redesign sales incentive compensation plans by better linking rewards with the salesperson’s achievements and the company’s strategic objectives. However, there has to be a mutual understanding between sales and finance of what success looks like so that incentives line up with the organization’s performance measurement systems. By utilizing ABC/M techniques, finance can provide salespeople with quality information that helps them understand the various cost components of their activities, their drivers, whether they can be influenced or not and their ultimate impact on bottom line.

With the right data, salespeople will have answers to their various questions. For example, “Whether to sell to existing customers through cross selling”, “Whether to use leads to tap new markets”, “What price is no longer worth making the sale”, and “What the financial impact of  sale is.” Finance therefore plays a critical role in helping the sales function achieve its effectiveness.

As sensibly as the sales function may plan and implement its strategy, it will not produce better leads, attract more customers and generate higher profits if the data is not used dynamically by finance. Finance ensures the timeliness of sales and sales-activity reporting. Finance is also capable of responding quickly to changing business situations with relevant reports and analytics.

How else can finance drive sales effectiveness?

I welcome your thoughts and comments.

ABC/M vs. Conventional Cost-Cutting

Business leaders always spend a lot of time thinking about costs and how they can reduce them, free resources for investment and improve the bottom line. The pressure to reduce costs is normally driven by cash flow position, shareholders, uncertainty, investments and the need to improve business performance. In light of the aftermath of 2008 global economic crisis, there has been increased pressure on business leaders, especially financial executives, to achieve more with less. The finance function has had to transform itself in order to improve productivity and efficiency.

If not managed properly, cost-cutting exercises may prove to be an unnecessary enemy that the company does not want to deal with. In some organizations, cost-cutting exercises have taken precedence resulting in the business becoming weak and more limited. On the contrary, if managed properly, cost reduction using activity-based costing and management techniques leads to better performance.

Cost-cutting measures should not be considered in isolation. Instead, cost-cutting should form part of the organization’s overall strategy because every investment, whether good or bad, is important. If the organization is not able to contain unnecessary costs, the impact will reflect in lower profits and cash flow problems. It is therefore important for managers to understand that no strategic planning process is complete without a close analysis of costs. At the same time, no cost or strategy project is complete without a closer look at its impact on the company’s capabilities system.

As Paul Leinwand and Cesare Mainardi clearly state in their book, The Essential Advantage: How To Win A Capabilities-Driven Strategy, the management’s approach to cost control is a key indicator of how coherent the company is or is not. Cost-cutting is meant to free up resources for strategic investments that are aligned with the organization’s capabilities system and way to play. If managers have no clear way to play and are cutting costs randomly, this fuels incoherence.

Unfortunately, some business leaders are still using the conventional approach of cutting costs with the hope of achieving positive results. So many at times, these leaders receive satisfaction only in the short-run. Adhoc across the board cuts, where a percentage of cost reduction is shared equally between functions, normally fail to free up the much needed investment.  This is so because adhoc across the board cuts negatively impact some parts of the company that are strategically aligned by stripping them off of the resources they desperately need to perform better. Also, most of these exercises are a benchmark of the competitors’ cost levels which by far are not linked to the company’s strategic priorities.

Using ABC/M techniques can help managers avoid the mistake of focusing on the short term. ABC/M helps identify cost drivers of different processes, activities, products, channels, customers etc. and this in turn help reduce waste by eliminating non-value adding activities. In 2008-2009, many companies across national borders implemented across the board cuts which were misaligned with their capabilities system and way to play. They instituted adhoc layoffs and cost reductions without considering the long-term implications on business performance and competitiveness.

As the global economy started to rebound, these companies found themselves in not so favourable positions of lacking the capabilities and skills essential to drive growth. In turn, they were forced to embark on massive recruitment sprees at huge costs to replace those skills lost during the downturn. On the contrary, those companies that implemented talent management strategies aligned to their overall strategies have managed to come out of the economic slump much better and stronger. This just shows that if the root cause of unnecessary costs is not identified and dealt with properly, they will come back again as if nothing was learned.

To cut costs and grow stronger, the conversation about costs needs to change to a more productive one. The starting point requires you to categorize your costs into costs you need to incur to keep the business running; costs you must incur to maintain your industry position even though your business might run without them; costs that support your capabilities system and way to play and lastly all other costs which are those that do not specifically fit into the first three categories. This distinction of costs helps evaluate the downside that the business would face if it makes cuts or changes in either one of these categories.

Today, many managers are facing the challenges of huge overcapacity and steep loses. The best way to react to these challenges is start looking at their businesses with fresh eyes. For example, to reduce operations costs, they need to start looking at operations as a single network and reconfigure production flows as needed to more flexibly serve customers.

Having eliminated unnecessary costs, the challenge for leaders is to deal with expense creep. It is important to ensure that cut costs do not come back because if these costs manifest again, this is a sign of strategic incoherence. The best way to avoid expense creep is to continuously evaluate costs relative to the organization’s capabilities system and way to play. Only by assessing costs regularly and consistently can the organization become aware of the relationship between its capabilities system and other expenses. In the long run, this will ensure a viable good cost position.

 

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