Profit Optimization: A Four Stage Strategic Process
Utilize the four-stage approach below to define comprehensive strategies that will optimize profitability for your organization.
For any organization, regardless of its strategic aspirations, industry niche, or current stage of growth, optimizing profitability is a perpetual imperative. While emphasis and execution may vary across industries, economic climates, and stages of the business lifecycle, it’s an unwavering cornerstone of sustainable success. To facilitate a clear and focused discussion, today we’ll utilize EBITDA margins as our metric, eliminating the non-cash impact of depreciation and amortization.
Our current economic climate creates some additional challenges. Although key indicators are improving, a potential recession looms, casting doubt on expected revenue growth and cash flows. Inflationary pressures push wages, material costs, and operating expenses upward, eroding profitability unless swiftly countered with price increases or other offsetting levers. Higher interest rates further tighten the screws negatively impacting return on invested capital, especially for businesses with unhedged floating-rate debt obligations.
This isn’t all bad news though. Challenging times present an opportunity for leadership to rise to the occasion. It’s the perfect moment to dissect processes, scrutinize vendor agreements, re-evaluate product portfolios, and fine tune pricing strategies. This deep dive can streamline operations, unearth hidden efficiencies, and ultimately, help craft bespoke strategies that deliver optimal margins and enable the business to achieve key objectives.
So, let’s delve into a proven strategic process you can implement to optimize profitability even as inflation rages and borrowing costs climb to the highest point in twenty-two years.
Stage 1: Define Optimal Profitability Targets
As Yogi Berra famously said, “You’ve got to be very careful if you don’t know where you are going because you might not get there.” This applies to all strategic planning. When dealing with profit optimization it’s critical that management doesn’t engage in initiatives that deliver short term improvements at the expense of long-term strategic objectives.
Frequently, we see management teams set goals without knowing the true potential of the business or defining optimal profitability. Performing a quick historical analysis and setting targets as the result of that analysis is a great way to short-change your organization. The targets set might be far from what’s truly attainable. For example, management may look at historical data and see that the business averaged an EBITDA margin of 13% over the past three years. Partially due to external factors, margins have decreased to 9% this year. Management establishes the initiative of “optimizing” EBITDA margins to return to 13%.
This may work to sustain the business. It may allow you to achieve the prior profitability levels, or even reach new levels of profitability. What this approach does not do is define the true potential for EBITDA margins. Opportunities to achieve 15% or 17% margins may exist, but they’ll never be attained because of the failure to define what is possible and optimal. Over time, these percentage points will become worth millions of dollars to stakeholders.
Looking at the example below, we can see ABC Co. – a (creatively named) hypothetical HR and payroll software company – has current EBITDA margins of 15.0% with a historical 5-year average of 13.5%.
By pulling individual company data for competitors and performing additional industry and market research they can establish industry average EBITDA margins as well as margins for similar sized companies. In addition, they can see best in class EBITDA margins are in the 28% range (not defined above).
At this point, ABC Co. can establish a few scenarios for what optimal EBITDA margins might be – best in class, high performer, industry average, similar sized company – and begin evaluating their performance against these benchmarks to establish attainable targets.
Let’s assume ABC Co. management has established the following benchmarks to measure themselves against, and set the associated targets:
ABC Co. can see that they’re lagging the industry average in all margin metrics while slightly outperforming similar sized companies in gross margin and operating margin. Management establishes the long-term goal of achieving best in class margins. Realizing there is a significant gap from current levels to best-in-class, they decide to conduct the optimization process in iterative steps. After some discussion, a decision is reached to target the high performer EBITDA margins benchmark during the first round of optimization initiatives.
Stage 2: Identify Key Profitability Levers
With benchmarks and targets established, management can move onto the next stage of our strategy building process: identifying the operational levers that drive historical performance and sanity testing the targets.
When thinking about optimizing profitability, many leaders set their sights on operating expenses. They establish intense focus on cutting costs or improving efficiency as the key to growing EBITDA margins. Undoubtedly, operating costs and efficiency are a significant component of the overall strategy. However, management is doing a disservice to the organization by not focusing on revenue and gross margins first.
We advise our clients to take a top-down approach to identifying operating levers. The guiding questions during this stage of the process should be:
What factors contribute most significantly to EBITDA margins?
Which of these factors do I have the most control over?
Which of these factors can help differentiate our business and establish a competitive advantage?
While the individual answers differ for all organizations, the most significant factors typically come from the following areas:
Product Offerings – Evaluating product offerings reveals opportunities to improve gross profit margins, which will flow through to EBITDA margins. Important metrics to consider include product mix, product quality, unit pricing, return rates, product adoption, and cross-sell or up-sell success.
Sales Operations – These metrics uncover opportunities to improve the sales process resulting in more units sold, higher margin units sold, reduced sales cycle times, and higher win rates for closed deals. Review lead generation initiatives, pipeline productivity and efficiency, training and educational materials, customer facing materials, and the current sales cycle to start.
Customer Satisfaction – Often overlooked, customer satisfaction doesn’t show up directly in the income statement. However, a deeper look reveals how critical customer satisfaction is to optimal margins. Highly satisfied customers result in lower levels of churn and returns, more frequent repeat purchases, and positive word of mouth marketing which reduces customer acquisition costs among other things.
Operating Efficiency – There is always an opportunity to become more efficient and improve operations. Example metrics to evaluate include operating expense ratios, employee wages as a percentage of revenue, revenue per dollar of wages, and return on ad spend. Different industries will have different improvement opportunities. Comb through the income statement and get creative!
After conducting the above exercise, ABC Co. produced the following output, detailing drivers of EBITDA margin. We can see internal, competitor, and industry performance all play a role in the evaluation.
ABC Co. has uncovered valuable insights that will help inform their margin expansion strategy going forward:
Product offering opportunities highlighted by the low percentage of customers purchasing subscriptions after free trial; improved pricing strategy potential based on competitor pricing and low revenue to dollar of wages metric
Sales training or process improvement opportunities highlighted by increasing sales cycles and stagnant average deal values
Opportunity to improve customer experience and satisfaction highlighted by the high rate of customer churn and poor customer sentiment shared in reviews and feedback
Organizational structure, commission plans, and other compensation improvement opportunities highlighted by the low revenue as a percent of wages; high employee turnover indicates potential to improve workplace culture
As ABC Co. did during their benchmarking exercise, it’s essential that management not only evaluate the company internally, but measure company performance against key competitors and the industry. If your business is having difficulty accessing this information or finding quality data, our team can provide benchmarking data and conduct a thorough analysis with actionable conclusions.
Stage 3: Sensitize and Prioritize Initiatives
Now that we’ve identified the biggest area of opportunity, we need to understand which operating levers present the highest level of risk and the most potential reward to EBITDA margins utilizing sensitivity analysis. The output will allow management to develop an organized and prioritized plan to attack current deficiencies and expand margins. Ideally, the business can focus on all areas of opportunity simultaneously but this isn’t always the case. Prioritizing the initiatives is key to allocating resources to activities that present the highest potential return.
During this stage, consider the following factors for each improvement opportunity:
Degree of Organizational Control
Timeline for Implementation and Impact
Maximum Potential Improvement
Improvement Impact on Margins
When aiding our clients with these exercises, we approach this task is with a dynamic operating model in Excel. Incorporate key performance drivers as independent variables that feed the rest of the model. While building an operating model is beyond the scope of this article, I’ll note that implementing selected operating levers as independent variables allows management to measure the impact of each variable in isolation, establishing a degree of sensitivity to EBITDA margins and revealing the most important initiatives.
Continuing the ABC Co. example: with the operating levers (metric line - independent variables) selected and the model completed, management calculated the specific sensitivities in the table below. The sensitivity calculation details the percentage change in EBITDA margin tied to a one-percent improvement in each of the chosen operating levers. Historical data and the correlation between individual operating levers and EBITDA margins can provide additional context.
ABC Co. management has determined that increasing the percentage of customers that subscribe to their premium software offering is the most impactful option. As the table above shows, a 1% increase in sales mix results in a 0.5% increase in EBITDA margin. Conversely increasing customer growth by 1% or decreasing customer acquisition costs by 1% results in only a 0.1% increase in EBITDA margin.
With sensitivities established, it’s time to determine the maximum expected improvement for each of these initiatives. Keep in mind the considerations mentioned earlier: degree of control and timeline for implementation. For the sake of simplicity, we’ll assume similar timelines for all potential initiatives. It’s likely improvements in one area will help other areas, compounding effect on margins.
Taking revenue per dollar of wages as an example, we can see a 1% improvement results in a 0.4% margin boost. Some options to increase this metric include:
Raising subscription prices for new customers and grandfathering in old customers
Improving the mix of premium subscription sales
Revising the commission structure to align sales incentives with strategic objectives
Reducing employee turnover
There are many other possibilities; the point here is by exploring different avenues to improving the defined operating levers, management can establish and apply an expected range of outcomes to prioritize their options. ABC Co. produced the following output after establishing the best-case, base-case, and worst-case scenarios for each of their initiatives.
By applying the weighted average of each scenario, ABC Co. management was able to come up with an expected EBITDA margin improvement for each initiative they identified. Since time and degree of control are assumed to be a non-factor in this example, the initiatives were then prioritized from the most impactful (premium sales mix) to least impactful (customer growth).
Stage 4: Communication and Implementation
With the initiatives defined and prioritized, it’s time to communicate the plan of action to the rest of the organization and begin implementation. This is arguably the most critical step. Clear communication and execution are everything. The most well-defined plans can fall to nothing if the right communication, resources, and capabilities don’t exist to promote a successful outcome.
Key components for a successful implementation include but are not limited to: having a defined project management hierarchy in place, open and clear two-way communication between all stakeholders, recurring formal progress reviews, and resources to support the initiative as needed.
Let’s examine why each of those items are so important:
Project Management Hierarchy – without a formal management hierarchy, the project will succumb to a state of anarchy. A clear hierarchy establishes accountability and creates a chain of communication and decision making that help improve efficiency. Clearly defined responsibilities allow management to see where bottlenecks exist and act quickly to implement solutions.
Open, Clear Communication – This is a basic management principle and is widely applicable outside of profit optimization initiatives. Clear communication of project strategy and expectations helps to create a sense of ownership and buy-in from the employees charged with executing the plan. Promoting feedback and employee engagement opens the door to new, innovative solutions that management may not consider otherwise.
Formal Progress Reviews – As the saying goes, “what get’s measured get’s managed.” It’s important for employees to understand this is a significant initiative, backed strongly by management. A lack of attention from management will lead to a lack of attention from employees and result in stagnation and failure.
Resources and Support – These initiatives are significant undertakings. Being able to adapt the strategic plan and pivot quickly will be a necessity. New processes or tools may need to be developed or implemented. Its critical management is committed to providing the support and resources needed for the team to achieve the desired outcome.
Concluding Thoughts
By using the four-stage approach outlined in this article, your organization will be able to successfully define a comprehensive strategy for optimizing profits. Best of all, this can be utilized as an iterative tool that supports several rounds of profit optimization initiatives.
Knowing organizational resources are allocated to the most impactful initiatives allows management to move quickly and confidently. Once the project begins, the processes outlined in the implementation stage help management quickly identify and address challenges to the project’s success.
Profit optimization should be an ongoing effort for all organizations. Should an economic downturn occur, your organization will be in the best position to withstand it. If not, your organization will be advantageously positioned to make investments in future growth initiatives.
If your organization is struggling to develop profit optimization strategies, we can help! Get started today with a complimentary discovery session!
