INTRODUCTION
As Finance Business Partners, we are always looking for ways to improve profitability. But how do you increase sales and reduce cost at the same time? For sustainable improvements, you need to put in place a structured approach that looks across the whole business to improve productivity.
As a finance professional, you can become the fulcrum of change and improvement, by identifying opportunities for improvement, calculating the financial upside of corrective action, and driving the improvement process.
In today's article, let's discover the processes necessary for enhancing revenue, optimizing costs, eliminating waste and maximizing assets and finance in order to transform the profitability of your business.
The overall approach is divided into 4 sections.
- Building the foundations for success
- Improving revenues
- Optimizing costs
- Maximizing assets and finance
Let’s explore each of these sections.
BUILDING THE FOUNDATION FOR SUCCESS
Improving business profits requires some basic fundamentals to be in place, before trickier issues are tackled, in terms of people, processes, objectives and strategy.
Key Motivation Factors
Most theories about what motivates peoples include three main things that employees want: interesting work, good working conditions, and the opportunity for growth. Motivation is based on the balance between effort and reward.
The flip side to this, and one of the biggest work problems, is boredom. Giving more challenging tasks to the most skilled employees, and less challenging tasks to those with lower skill levels can help.
The Importance of Communication
Poor or negative communication can undermine the efforts management are making to achieve their objectives, and can reduce trust in the leadership. It also creates workplace tensions that can lead to low morale, wasted time, conflict, loss of valued staff and, ultimately, poor operational results.
Managers being visible and approachable can foster an understanding of processes and problems at a ground-floor level. An open, collaborative style will achieve far more in promoting good morale, than a directive and dictatorial approach.
Setting Business Objectives
Objectives are the short-term steps designed to achieve a specific goal. Goals are a more general statement of what the business hopes to achieve over a longer term.
Goals must be realistic – challenging, but attainable. They must also consider people’s skills sets and abilities and be framed within the constraints of the financial and human resources of the organisation.
Key Success Factors
Key success factors are a valuable indicator of how the business has progressed and of future problems which might arise. They give insights into the business performance and enable managers to take any necessary action in a timely manner.
Success factors must be an intrinsic part of the planning of objectives, to help monitor whether progress towards objectives is being achieved.
Diversification
Diversification is a strategy adopted to widen the scope of a business, open up a new market and, consequently, increase revenues and profits.
There are three approaches to diversification and conglomerate diversification is the riskiest:
Concentric diversification: Widening the product range.
Horizontal diversification: New and unrelated products or services to existing customers.
Conglomerate diversification: New products or services that are significantly unrelated, with no technological or commercial similarities.
Improving Business Processes
Many businesses resist improvement initiatives because of the expense and disruption involved. But, those that refuse to make the quantum improvements technology can bring are in danger of being left behind.
Process improvements can be formalised, for example via systems-based approaches such as Six Sigma, Lean methodology or Total Quality Management.
Going Digital
Digital transformation can be seen as a costly and unnecessary commitment, but ultimately, it is the businesses that do adapt and adopt that are reaping the benefits. Going digital at some level isn’t really just an option – it’s a necessity. Customers now expect a business website, and increasingly a responsive digital presence.
It is important to have a responsive workforce that can adapt to change and rise to challenges. Businesses should be trying new technologies, to improve customer engagement and experience.
Data analytics should be leveraged in all improvement initiatives including customer analytics, operations analytics, people analytics and financial / accounting analytics.
IMPROVING REVENUES
Here we need to understand how to persuade customers to choose your service/product over a rival’s, considering strategies to generate revenue and drive up profits.
Customer Profitability Analysis
Customer profitability analysis (CPA) allows a business to focus attention on the most profitable group of customers – segmenting the customer base, to determine the revenues and costs attributable to each. Profitable segments can then be maximised, and non-profitable segments reduced or eliminated.
It might be possible to make some customers profitable, by increasing revenue and/or decreasing costs, i.e. charge additional fees, or use a differential pricing strategy.
Brand Value
Brand value is the starting point to building a clear identity for a business and its products. It represents the brand’s characteristics and what the business stands for.
Brand values shape marketing strategy. It is the image and tone the business wants to create and communicate. Staff should understand and accept them and carry out activities in accordance with them, so that the public face of the business is clearly underpinned by the values.
The Product Life Cycle
The period from development to maturity is known as the product life cycle, and it has a direct bearing on profitability. Businesses should extend the maturity phase for as long as possible, because this is when most profit is made.
Product life cycle extension strategies include advertising, new markets, repositioning, price changes, new features and repackaging.
Product Planning
A product strategy estimating life of a product and considering the whole of the product life cycle can help a business be proactive, rather than reactive to competitor or market changes.
It should extend a product’s life and stimulate sales growth as the product matures by planning to extend market reach and consider new products, new customers and new uses for existing products.
New Market Barriers
Entering a new market is not an easy task and there are often considerable barriers to overcome, including high investment costs, combatting economies of scale and regulation/legal restrictions, competing with existing brand identities, supply and distribution issues and rival retaliation.
Pricing Issues
There are at least three levels of pricing a business should consider:
- Cost-plus pricing: Product cost plus a margin or a mark-up.
- Market-based pricing: What rivals charge for similar items.
- Actual pricing: What customers actually after discounts or rebates.
One key consideration is the price sensitivity of your customers.
Value-based Pricing
Value-based pricing sets prices primarily, but not exclusively, according to the perceived or estimated value of a product/service to the customer. This can be very complicated to work out.
Maximizing Gross Margin
Gross profit, is the difference between the selling price of an item and the direct cost of producing it. It does not include indirect overheads.
The objective is to maximise gross margin – to generate as big a bottom line as possible. Strategies include price increases, focusing on high-margin items, increasing sales volumes, rebranding for new markets, cost reduction, inventory management and innovation.
Upselling
Upselling is the practice of encouraging customers to purchase a higher-end product than the one under consideration, while cross-selling invites customers to buy related or complementary items.
They are mutually beneficial, providing maximum value to customers and increasing revenue, without the recurring cost of marketing. It’s not about trying to sell people things they don’t need, it’s selling them things they do need, but didn’t know they could get from you.
Innovation Strategies
Innovation needs to be part of a strategic approach, to revitalise existing products and to bring new products to market – generating new sales opportunities.
Key aspects of a successful innovation strategy are staying ahead of trends, building customer relationships, pooling resources with suppliers or business partners and using employees to generate innovative ideas. To do this you must promote creativity and innovation in the workplace.
OPTIMIZING COSTS
Let’s looks at some methods designed to optimize costs, deliver value, and eliminate waste and non-value added costs.
Optimizing costs is not an easy process and, if handled badly, can damage a business. Strategies need to be carefully thought through, if they are to succeed.
Cost Optimization
A business must have a clear view of its strategy and, more importantly, communicate it consistently across the organisation. Costs can then be aligned with strategy, to identify those that add value. Non-value adding costs are reduced or eliminated.
Cost optimization is not simply cost cutting and is rarely simple! A culture of cost optimization needs to be fostered, led from the top. It must also be presented positively, and ideally tackled when the business is doing well.
Identifying Opportunities
The key to cost optimization is to target resources where they can best benefit the business. Clearly some costs will directly benefit a business (i.e. delivery costs), whilst others have less tangible benefits (i.e. marketing).
A cost optimization programme should identify costs which enable a business to deliver what customers want, at the right times, at the right price, and at a cost level that enables it to move forward, innovate and develop new opportunities. The key is to isolate and review cost drivers that can be controlled, with a view to achieving maximum cost efficiencies.
Who is responsible?
A cost optimization programme will require policies and procedures that must be adhered to from the top down. Initiatives must be championed by senior whose role is to set the strategy, sell the process to the whole business and provide drive and motivation for the programme.
The involvement of staff at lower levels ensures that the people managing costs are those closest to the processes involved, and that cost management does not hurt the business. Cost optimization should be part of a business growth strategy and not built around an illusory target.
Strategic Initiatives
There are some strategic ways of reviewing how costs are generated in the business and how, consequently, they may be reduced or eliminated. The principle behind cost optimisation is to reduce costs that create value, or are business essential, and to eliminate or minimise costs that do not create value.
Value stream analysis maps a process from supplier to customer to identify bottlenecks, waste and inefficiencies and to consider cycle times. The key is to revise the flow to make it as simple as possible.
Process mapping looks at internal processes in more detail, so that unnecessary tasks and duplicated activity can be identified and dealt with. The people who actually carry out each process must be involved.
Waste Reduction
Issues associated with reducing waste can be addressed by adopting a continuous improvement programme. Mapping business processes in detail reduces the risk of causing damage and helps direct focus at removing duplication, non-added value activities and other inefficiencies.
Areas where attention can be directed specifically include bottlenecks, balancing workflows, best practice and continual improvement with the right level of involvement.
The Supply Chain
Suppliers often have power making cost reduction hard in this area. But, many businesses can now outsource all, or part, of their operation. Manufacturers can outsource components to specialist providers, and other businesses can use agencies or service providers to reduce staff costs.
The quality of any outsourced service needs to be clearly established using a detailed service level agreement specifying exactly what is expected of both sides. Outsourcing can impact the culture and workflow of a business, so it must be considered carefully. Management must balance the cost savings and improved efficiency, against the loss of control and potential problems.
The basis for costing
The Supply Chain
Fixed costs are included in the cost of a product/service, on the basis of some form of allocation, for example, as a rate per labour or machine hour. It recognises the importance of including fixed costs when establishing a suitable pricing policy.
Marginal costing
This into account only variable costs that rise or fall in line with the activity level. It can be used to inform short-term decision making in a way that absorption costing cannot.
Activity-based costing
The basic idea of ABC is that, instead of seeing indirect overheads as one big pool and using one cost driver, we break the overheads into smaller pools and use a series of more relevant drivers to allocate them to products/services. It looks at processes, not just costs.
Delabole
Service-based businesses carrying out cost optimisation strategies often face some common issues. Most of their costs are fixed, and staff often highly skilled, difficult to replace and expensive to employ. The quality of outsourcing is also very important (impacting on customer service and satisfaction).
MAXIMIZING ASSETS AND FINANCE
Finance can be expensive and, in difficult times, the cost of borrowings can prove too much. A business needs to be able to generate cash, to minimize borrowing and finance itself.
Considerations
The process of improving profits should start with a plan. The process of setting financial targets is straight forward in theory, but more complex in practice. All the factors involved in strategic decision-making are interconnected.
Budgeting
Businesses of all sizes will prepare detailed budgets for the next year. Looking ahead strategically involves a more broad-brush approach, with less detail and a consideration of themes and trends, rather than absolute values. The further ahead a plan forecasts, the less precise the outcome.
Budgeting is a critical management processes. They are an instrument of planning and control, and can be used to incentivise, or act as an indicator of performance. Many businesses use a worst case/best case approach, or a likely expected outcome range.
Budgets and Sensitivity Analysis
Strategic planning and budgeting requires businesses to evaluate a range of outcomes, using different projections of revenues and costs – to arrive at a realistic and achievable estimate of future performance. Management must consider two key issues: the margin generated by their range of products and services and the level of fixed costs to be met.
Tangible Assets
Businesses that have assets which are not delivering value are simply incurring costs for no purpose. A business should dispose of assets that do not add value, unless they are held for investment or future use, and ensure that retained assets work as hard as they can for the business.
The asset/turnover ratio identifies how well the assets base of the business is being used to generate revenue. It should improve after a business has implemented a cost optimisation and revenue improvement programme. Look at the trend over a period and in comparison with other businesses in the same industry.
Intangible Assets
More than 80% of the business value is created by intangible assets which are not recognized in our balance sheets including corporate brands, customer relationships, human capital, social / relationship capital, intellectual property, natural resources etc..
Therefore, it’s really important to understand the value beyond the balance sheet in order to maximize sustainable business profits.
Managing Cash
If a business has a positive cash flow it can fund its working capital, by taking supplier credit. Short-term funding, i.e. an overdraft, can be used to bridge any gap between cash receipts and payments. Overdrafts are flexible and fluctuations link to the level of trading activity. For medium to long term funding a loan is better. They are fixed, with known repayment schedules and funding is secure for the loan period.
Working capital management is based on control. Effective inventory management, customer credit control, maximising supplier credit and ensuring overdrafts and short-term loans are used carefully to avoid excessive interest charges.
The operating cash cycle (OCC) is the length of time between the purchase of goods for inventory and the receipt of funds from the sale of those goods. It varies with the type of business.
Inventory Management
Inventories often form a significant part of the statement of financial position. The key to managing inventory is to hold as little as possible and to turn the inventory over as many times as possible in a financial period.
Manufacturers tend to use inventory control systems such as just-in-time (JIT), whilst efficient inventory management in retail often involves barcodes, and pre-set stock/reorder levels.
With JIT a business maintains very low inventory levels, and relies on its suppliers to deliver items just in time to be sold. Economic order quantity (EOQ) is the order size that should be sent to the supplier in order to minimise the total annual inventory holding costs of the business.
Managing Receivables
Terms of trade set out the number of days’ credit, from the invoice date, given to customers before the invoice becomes due for payment. The key to managing receivables is credit control, usually a multi-stage system. Aged receivables analysis is an analysis of the amounts due from customers over time.
Debt factoring and invoice discounting are ways to improve cash flow from receivables. With debt factoring a finance company “buys” the invoicing from the business, at a discount, then collects the sums due in full. With invoice discounting, the business borrows money from a financial provider, based on invoices issued.
Managing Payables
Trade credit is one of the main sources of short-term finance for businesses. Many suppliers offer discounts for early or prompt payment, which can be an opportunity to reduce purchase costs and increase margin. Other considerations are whether early payment increase an overdraft and what you could do with the extra funds.
If the cost of credit is less than the cost of capital (the interest on borrowings) you should probably take the discount. But, if the business is cash positive, maybe that cash can be used to make a higher return in another way.
CONCLUSION
Every accountant & finance professional will tell you it’s a very simple thing, improving business profits, which is increase revenues and/or reduce costs. However, it’s not quite as simple as that, I don’t think.
So whilst in theory it sounds simple, in practice, it isn’t. And some of the secrets of improving business profits are not much to do with directly cutting costs or increasing revenues, they are about re-energising the business, changing the way things are done.
So the cost-cutting and revenue improvement come out more as incidentals to a process of change and evolution than as a distinct program of “let’s cut costs by 10% and therefore improve our profits”. That way, madness lies in business management.
If you aspire to become a world class Strategic Finance Leader by upskilling yourself or your finance team or want to take improvement initiatives in order to transform the profitability of your business using our range of business solutions including case studies for each of these improvement processes discussed above, then visit our website and reach out to us for free consultation regarding your finance career, finance function or business.
This into account only variable costs that rise or fall in line with the activity level. It can be used to inform short-term decision making in a way that absorption costing cannot.
