Do You Truly Know Your Core Customer?

Do You Truly Know Your Core Customer?

Who is your Core Customer?

In working with many clients on improving their business and developing a growth model, we soon get into the issue of their “Core Customer.” I have realized that many have not given this much thought and cannot easily define their “Core Customer.” Your Core Customer is the customer you are targeting, the customer that is preferred, and the one that your marketing and sales efforts are focused on. A Core Customer has the following attributes:

  • A real person with wants, needs, and fears.
  • Will buy for optimal profit.
  • Has an unique online identity and behavior.
  • Pays on time, loyal, and refers others.
  • Exists today among your customers

Not knowing your Core Customer is not a terrible problem, as we can quickly work through a session to put a definition in place. However, a more complicated issue is knowing their Core Customer but unable to define their “Economic Engine,” or profitability per customer. Lack of good data is always a severe problem! If you can’t measure something, then your performance is purely an assumption, and down that road is chaos.

Profit per Customer

If you don’t know your profit per customer, the customer you consider your “Core Customer” may generate sub-par profits pulling down the company’s performance. During a recent conversation, a CEO told me their metric was revenue per employee. While that would generate top-line revenue, it does nothing for profit, efficient customer targeting and marketing, or market differentiation. The business adage, “We are losing money on each item, but will make it up on volume,” seems to be the driving force.

Many companies I have worked with cannot tell me the profitability per customer and so work on the assumption that they are performing well, but cannot understand why they cannot scale and have profit and cashflow issues. Also, often their data is corrupted by the “Flaw of Averages.” So to paraphrase the proverb, “First get your data.” Sometimes getting good data on project costs is difficult, but without there cannot be:

  • Knowledge of performance;
  • Plans for improvement;
  • Measurement of improvement.

And “Hope is not a strategy.”

Select the Right Core Customer

Once we have data showing your Core Customer’s profitability, we can determine if they generate optimal profit. Since a requirement of a Core Customer, as mentioned above, if your Core Customer is not generating optimal profit, then there are one of two choices:

  1. Change your economic model so that they do, or
  2. Change your Core Customer.

When examining the data, many companies have found that the companies they were targeting as their “Core Customers” were their less profitable customers and ones that everyone in the market was fighting over. Targeting a different segment of customers that generated optimal profit could increase its profitability and differentiate itself from its competition, a great “Blue Ocean” strategy.

Lake Truck Lines, a Gravitas client, was focused on large customers. However, when analyzing its data, Lake Truck Lines realized that everyone was targeting those customers so there was pricing pressure and low margins. By make mid-sized customers its Core Customer, the company was able to operate with less competition and generate the optimal profit per customer. Similarly with Build Direct, focusing on young women seeking to do DIY, it was able to realize a much higher margin and operate in “Blue Ocean” waters compared to when it was focused on supplying general contractors.

The time spent analyzing your clients, their profitability, and your Blue Ocean possibilities can result in you operating at higher margins with less competition.

Profit / X

I have discussed the “Economic Engine” before, but it is the concept of “Profit/X,” Profit/X is the crucial part of your strategy, and it must:

  • Tightly aligns with your BHAG®
  • Be the fundamental economic engine of your business
  • Be a single overarching KPI to scale your business
  • It must impact revenue while controlling cost.
  • More X must be desirable.
  • It must be unique within the industry – you have to differentiate yourself from your competition.

What is critical is finding a Profit/X that is unique within your industry. If you choose the same Profit/X as everyone else, you are all competing on the same drivers, and you cannot differentiate yourself from your competition. Having identified our Core Customer, the appropriate Profit/X can be identified. Picking the wrong Profit/X given your Core Customer again will lead to sub-optimal results. These two concepts are interconnected and for you to achieve the best results, you need to determine both and have them connected.

Having the Right Profit/X

If your Profit/X is defined as profit per employee, you have only three ways to achieve this: increase the price, improve employee performance or cut the product’s quality. Since price should be driven by value creation, not employee profitability, raising prices may be difficult. We do not want to cut value delivery, and driving employees harder is no recipe for success. Thus a better metric may be profit per customer.

With customer size, if you are servicing large customers it may require longer larger projects compared to mid-sized companies. If mid-sized companies have more set up and administrative costs then your Profit/X must be different between the two.

There are many examples of Profit/X from Southwest Airlines’ profit per plane to a dry cleaner who measured it by profit per delivery truck. The key is to find the one that drives your business and will also differentiate yourself.

Conclusion

Many CEOs and Business Owners are salespeople and are not interested in digging into the financials and getting to the data I have discussed above. However, the effort is well worth it, as once you have a clear understanding of where you are, you can:

  • Target marketing towards your Core Customer;
  • Differentiate yourself from your competition;
  • Ensure that all projects, services, or products meeting your Profit/X to ensure profitability; and 
  • Position yourself for growth and profitability. 

Get your CFO, your team, and a coach and spend a day or two to determine the ideal results. The payoff will be huge.

 

Copyright (c) 2021 Marc A. Borrelli

Does Your Financial Model Drive Growth?

Does Your Financial Model Drive Growth?

Working with many companies looking to grow, I am always surprised how many have not built a financial model that drives growth. I have mentioned before a financial model that drives growth? Here I am basing on Jim Collin’s Profit/X, which he laid out in Good to Great. So then we have to delve into what is Profit/X. This is the key financial metric that drives profitable growth by defining some profit number per some “X” that results in:

Passion. Your employees are passionate about the “X” and excited about increasing it.
Empowerment. Your employees are empowered to make decisions to ensure the baseline Profi/X is met.
Drive. It drives behavior to generate profit and growth.
Discipline. It provides the financial discipline to ensure that the organization remains profitable as it grows.

Thus is it is your Economic Engine that will enable profitable growth.

Many people look for a quick answer in determining Profit/X, but there is no quick answer. It is an iterative process that will get there, but no something you necessarily come up with on the first try.

Profit can be:

  • Gross Profit,
  • Operating Profit,
  • Net Profit,
  • Gross Margin,
  • Operating Margin, or
  • Net Margin,

to name a few.

“X” is very variable and can be:

  • “Product/Service,”
  • Customer,
  • Invoice,
  • lb,
  • pallet,
  • truckload, or
  • plane.

For a better understanding of Profit/X, my video below may help explain it better.

Profit/X

It is well worth your time to develop your Profit/X and get your employees to understand it and embrace it. The discipline it provides combined with the drive and empowerment it delivers makes a very strong economic engine and ensures continued profitability through your growth.

 

Copyright (c) 2021 Marc A. Borrelli

 

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Why is there not MORE common sense

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Do You Understand Your Costs to Ensure Profitability?

Do You Understand Your Costs to Ensure Profitability?

You can only determine profitability when you know your costs. I’ve discussed before that you should price according to value, not hours. However, you still need to know your costs to understand the minimum pricing and how it is performing. Do you consider each jobs’ profitability when you price new jobs? Do you know what you should be charging to ensure you hit your profit targets? These discussions about a company’s profitability, and what measure drives profit, are critical for your organization.

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Sunk Costs Are Just That, Sunk!

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Do You REALLY Know Your Business Model?

Do You REALLY Know Your Business Model?

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Do You Understand Your Costs to Ensure Profitability?

Do You Understand Your Costs to Ensure Profitability?

During a recent call with a CEO, we discussed the company’s profitability and what measure they used to drive profit – basically Profit/X. It became apparent that they didn’t have a handle on their costs and what they should be charging to ensure they hit their profit targets. I have addressed this a bit before to ensure that your margins were where you wanted and rejecting low-profit jobs. However, this time the issue is to understand the jobs’ profitability and price new jobs effectively.

The Costs

To determine profitability, we need to know our costs. Thus, we built a table listing every employee, the salary, additional expenses, e.g., health insurance, 401k, etc. (estimated at 35% of wages), and the amount of billable time. As a result, we had a table that looked like the one below.

Employee Costs

Calculate Hourly Costs

From this Table, we could determine the hourly cost of an employee. To calculate actual costs per hour, we took the number of billable hours, which for 2021 is 8,760, and subtracted 96 hours, the allowable PTO. However, most employees don’t work their total billable hours for various reasons, so we included a “slack” factor of 10%. For multiple reasons, most projects have “re-work” or errors that cannot be billed and estimated at 10% and included. As a result, the total “Billable Hours” was 7,800 rather than 8,760. These adjustments allowed us to produce the hourly cost for each employee.

Calculate Overall Costs

Taking that data, we then divided the hourly costs into billable and non-billable. We added fixed overhead, which was not related to billable expenses, e.g., CEO’s pay, office rent, etc. Thus, we now had a cost structure for the firm that looked as follows.

Billable Costs $1,099,150
Non-billable Costs 1,194,500
Overhead 750,000
Total Costs $3,043,650

Calculate Revenue

With the company’s cost structure defined, we could determine how much to markup hourly costs to make a 25% profit. Doing this analysis is easy in Excel; however, ensure you don’t make easy Excel mistakes. , and the result was that marking up hourly costs by 232% would enable the company to meet its profit goal. This analysis is shown below.

Revenue $4,056,895
Total Costs 3,043,650
Profit $1,013,245
Profit Margin 25%

 

Pricing of new projects

While I am a strong proponent of selling value, not time, if the company wants to know the minimum price to charge to realize its minimum profit, it can use this data. Identifying which employees will work on the project and for how long. For example, they would be able to cost it as follows:

Employee Hours Hourly Billable Rate Total Billable Charge
#3 25 $49.32 $1,233
#6 5 44.77 224
#10 20 43.83 857
#15 15 30.50 457
#17 10 48.67 487
Total     $3,258

With this data, we can now estimate jobs more effectively since we know the employees who will work on the jobs and how many hours they will commit. We have to build some waste into that model, but we have a good idea of how to price jobs.

 

Performance Table

Also, we can see either weekly, monthly, or quarterly how the company is performing. If we produce a table of the employees and clients and hours worked for a month, we can see the utilization of each employee and profit per client as follows.

Employee Utilization and Job Profitability

This table provides a good insight into the company’s and employees’ performance. As can be seen, Employees #3 and #6 are working more than their billable hours with utilization rates above 100%. While this may be good, one would need to ensure that whatever they were supposed to be doing with their non-billable time was being done. Also, Employee #9 is utilized 71.3% of the time, resulting in lost efficiency. Further analysis is required into why this is the case, but it identifies potential issues. Finally, it would appear that nearly half of the employees are working at less than 95% utilization. Given that the company’s utilization is already adjusted for “Slack” and “Rework,” analysis to understand why utilization is low is required.

We cannot only analyze employee performance, but we can see how we are doing with our various contracts. Clients #1 and #3 are losing money, while Client #4 is profitable. The data doesn’t tell us why, but again that would be work investigating as the company is performing below its goal of 25% profit.

Conclusion

As I stated at the beginning, concerning pricing, I strongly believe in pricing according to value and not hours; however, this analysis and methodology are helpful to understand what an organization’s minimum pricing should be and how it is performing. While several issues are highlighted and require more work, this provides a great way of knowing what to examine to improve performance.

If you would like to do this analysis, call me. I would be happy to help you.

Copyright © 2021, Marc A. Borrelli

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Do You Understand Your Costs to Ensure Profitability?

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You can only determine profitability when you know your costs. I’ve discussed before that you should price according to value, not hours. However, you still need to know your costs to understand the minimum pricing and how it is performing. Do you consider each jobs’ profitability when you price new jobs? Do you know what you should be charging to ensure you hit your profit targets? These discussions about a company’s profitability, and what measure drives profit, are critical for your organization.

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Sunk Costs Are Just That, Sunk!

Sunk Costs Are Just That, Sunk!

Working with my Vistage group this week, we had an exciting discussion about “If you were starting your business today, what would you do differently?” This discussion made me think of sunk costs and how they limit us. I have discussed how to make better decisions before, but sunk costs deal with our assumptions.

What are sunk costs? A sunk cost is a payment or investment that has already been made, and it is sunk because it is unrecoverable no matter what. So, it should not be a factor in any decisions from now on.

The Sunk Cost Fallacy

The sunk cost fallacy is when an action is continued because of past decisions (time, money, resources) rather than a rational choice of what will maximize the returns at this present time. The fallacy is that behavior is driven by an expenditure that is not recoupable regardless of future actions.

For example, a company that decides to build a new software platform. They have done their analyses and determined that the future benefit they will receive from the software will outweigh its development cost. They pay for the software and expect to save a specific cash flow level from the software’s production each year. But after a few years, the platform is underperforming, and cash flows are less than expected.

A decision has to be made: should the platform be abandoned or not? At this point, the software’s initial cost is a sunk cost and cannot be recovered. The decision should only be based on the future cash flows—or the future expected benefit—of the platform compared to the value of replacing it today, not the original cost of the software.

However, businesses, organizations, and people often have difficulty abandoning strategies because of the time spent developing them, even if they aren’t the right choice for the company or individual. Therefore, recognizing what a sunk cost is will result in better decisions. 

How sunk costs sabotage us

Here are a few ways, but this list is not exhaustive.

At Work

Bad Pricing

Companies often justify pricing based on their costs. Most commonly, the R&D expenditure to develop the product. Whatever the R&D costs were, they are irrelevant to the pricing. The market will only pay what the product is worth, not what was invested in it. A pharmaceutical company’s attempt to justify high prices because of the need to recoup R&D expenses is fallacious. The company will charge market prices whether R&D had cost one dollar or one million dollars.

Similarly, many businesses price their services on the hours it took to deliver a service. However, the costs of providing the service are sunk, and you cannot recoup them. The market will only pay you what they deem the value of the product or service to be, so using pricing to recoup costs is “backward.” Instead, one should determine the price and then figure out how to deliver the product or service at the profit margin desired.

Consider if a company invested $100,000 to produce a product and planned to sell them at $100 each. However, the day after the product launch, a competitor announces a better competing product at $50. Will anyone pay $100 for an inferior product when the best one is available for $50?

Bad Investments

Sunk costs are why so many investors tend to remain committed or even invest additional capital into a bad investment to make their initial decision seem worthwhile. How many times has an investor tell you, “As soon as X gets back to what I paid, I am selling.” Why?

What they paid is paid. The investor cannot change that; it is a sunk cost. The real question is, “Does X offer higher returns in the future than Y, some other asset I am considering, after transaction costs?” If yes, then stick with it. If no, switch out X for Y. 

Assume you spend $4,000 on a wine tour of Napa. Later on, you find a better wine tour to Bordeau that costs $2,500, and you purchase that trip as well. Later, you realize that the two dates clash and the tickets are non-refundable. Would you attend the $4,000 good wine trip or the $2,500 great wine trip? The $2,500 trip. The $4,000 trip is irrelevant in consideration because it is inferior, and the money is gone.

Bad processes

Returning to my initial question, “If you were starting your business again today, what would you do differently?” Many people will give outstanding examples of what they would do differently but never consider making the change because of the investment they have in their current process. As with assets, if your current process generates a cash flow of $X per year, and switching would generate some cash flow greater than $X after the costs of switching, you should switch.

Misaligned employees

Many companies have employees whom they know are subpar. However, they cannot fire them because they have been employed for a long time or the company has invested some amount in them. This situation is most often seen with those employees who have been with the organization since the beginning. However, the organization has outgrown them. 

Again, the time invested by the company and the employee are sunk costs. The decision is what is the best investment going forward. If a more significant return is achievable with a new employee, then the change is required.

Sunk Costs Exist in Our Personal Lives Too

Feel free not to ski in bad weather.

You may be considered a fair-weather skier, but the cost became sunk when you purchased your ticket. You might feel obligated to stay and stick it out if the ticket was expensive or you have a limited holiday window, but if not skiing in a freezing whiteout makes you happier, do it! Either way, you aren’t getting your money back.

Don’t go to the gym just because you have an annual membership.

While working out may be advantageous to your health, your annual membership shouldn’t dictate whether you go to the gym on any given day. If you have paid up front, then the money is gone. So if you would prefer to take a hike, ride a bike, relax and meditate, you should. However, I am not saying there may be more benefits to working out.

Don’t grow up to be a lawyer.

I chose lawyers because I was this example; however, I decided before I graduated law school that I didn’t want to be a lawyer. Assume you went to law school, passed the bar, started working, and then realized you hate being a lawyer. What should you do? You invested so much time, energy, and money in that degree, so it can’t be worth starting over again with a new career? Unfortunately, time, energy, and money are all sunk costs, so if your end goal is your happiness, you might need to cut your losses and refocus your energies elsewhere. 

With the above examples, next time you face a decision, ignore all the sunk costs; you will make better decisions for your organization and yourself.

Copyright (c) 2021, Marc A. Borrelli

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Do You Understand Your Costs to Ensure Profitability?

Do You Understand Your Costs to Ensure Profitability?

You can only determine profitability when you know your costs. I’ve discussed before that you should price according to value, not hours. However, you still need to know your costs to understand the minimum pricing and how it is performing. Do you consider each jobs’ profitability when you price new jobs? Do you know what you should be charging to ensure you hit your profit targets? These discussions about a company’s profitability, and what measure drives profit, are critical for your organization.

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Sunk Costs Are Just That, Sunk!

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Do You REALLY Know Your Business Model?

Do You REALLY Know Your Business Model?

Bringing clarity to your organization is a common theme on The Disruption! blog. Defining your business model is a worthwhile exercise for any leadership team. But how do you even begin to bring clarity into your operations? If you’re looking for a place to start, Josh Kaufman’s “Five Parts of Every Business” offers an excellent framework. Kaufman defines five parts of every business model that all flow into the next, breaking it down into Value Creation, Marketing, Sales, Value Delivery, and Finance.

Do You REALLY Know Your Business Model?

Do You REALLY Know Your Business Model?

Clarity is a repeated theme of mine and The Disruption!, whether in regards strategy or how you make money. Listening to Josh Kaufman discuss his “Five Parts of Every Business” and the need to define your business model while presenting this information clearly magnified the point.

 

What Are The “5 Parts of Every Business”?

Kaufman says in every business model there are “5 Parts of Every Business,” each of which flows into the next:

  1. Value Creation: A venture that doesn’t create value for others is a hobby.
  2. Marketing: A venture that doesn’t attract attention is a flop.
  3. Sales: A venture that doesn’t sell the value it creates is a non-profit.
  4. Value Delivery: A venture that doesn’t deliver what it promises is a scam.
  5. Finance: A venture that doesn’t bring in enough money to keep operating will inevitably close.

 

Value Creation

Kaufman defines Value Creation as “Discovering what people need or want, then creating it.”

Most customers don’t know what they need or want. As has been pointed out many times, people wanted a faster horse, not an automobile. However, whatever they want, in reality, they are just seeking a solution to a problem. Therefore, the critical issue is determining “What problem you are trying to solve?” Or, as Clayton Christensen said, “What is the job the customer is hiring you or your product to do?”

Defining this is often hard, as many companies don’t know what job their clients are seeking them or their products to provide. I have discussed this before. However, as the adage says, “people aren’t buying drills, they are buying holes.” This is a vital part of your business model.

So, working with your team to determine “the job to be done” and your “Core Customer” is well worth the effort because you can better describe what you do, and all your employees will better know what you do and how what they do impacts it.

 

Marketing

Kaufman’s definition is “Marketing is defined as attracting attention and building demand for what you have created.”

In today’s digital world, with Google, Facebook, Linked In, and Instagram, marketing separating yourself from the masses is hard, especially if people don’t understand the product and service. Therefore, by focusing on the job to be done or the problem you are solving, it easier to stand out among the crowd.

Also, as you identify what the “job to be done” is, you can better identify your Core Customer. Remember a Core Customer is:

  • An actual person with needs and wants. If you sell B2B your core customer is still a person because you have to convince a person to buy.
  • Who buys for the optimal profit.
  • Who pays on time, is loyal, and refers others.
  • Has a unique online identity and behavior; and
  • A customer who exists amongst your clients today.

Build Direct started as a company supplying contractors. However, it soon realized that while contractors were a key customer component, they were not the company’s Core Customer; instead, Build Direct’s core customers were young female DIYers interested in the products and education. Build Direct focused its marketing according to that recognition and started providing much educational content for young female DIYers. This specific marketing drove much better brand recognition and engagement.

Also, South Shore Furniture in Canada identified their core customer as “Sarah.” Sarah is so vital that there is a mannequin of Sarah in all meeting rooms, so no one forgets whom they are seeking to serve.

Besides, marketing to the correct demographic is easier and more fruitful if you know your Core Customer. Without this information, the marketing section of your business model is just hope, not a strategy!

 

Sales

Kaufman defines sales as “Turning prospective customers into paying customers.”

However, as Jeffrey Gitomer, put it “People don’t like to be sold, but they love to buy.” So the key is how do you move prospects into customers? Businesses have to earn their prospects’ trust and help them understand why it is worth paying for the offer. Another way of looking at this is, “What is your brand promise?”

Companies need to know what their brand promise is. For example, Starbucks is “Love your beverage or let us know and we will always make it right.” Some organizations may have supporting brand promises to prove more definition of the brand promise. Your brand promise must be measurable, because as Peter Drucker said, “What gets measured gets managed.” So if it is measurable and measured, the organization can ensure that it meets its brand promise, which provides more assurance to the prospect. Finally, with a clearly defined brand promise that is measurable, the organization ends up saying “No” more than “Yes” to opportunities and ideas since they will damage the brand promise.

Since no one wants to be taken advantage of, Sales is about educating the prospect to identify what is essential to convince them you can deliver on your promise. A clearly stated brand promise that is measured and quantified increases the ability to persuade the prospect to purchase from you. It amazes me how many business models don’t have a brand promise.

 

Value Delivery

Here Kaufman defines Value Delivery as “Giving your customers what you’ve promised and ensured that they’re satisfied.” With this, I have no issues. Anyone who doesn’t deliver what they promised is effectively a “scam artist.”

To ensure you that make the customer satisfied, you have to exceed the customers’ expectations. A popular way to determine customer satisfaction is through Net Promoter Score scores which we see more and more (if you are looking for help with NPS surveys of your customers, contact me). You want more promoters and detractors. However, the NPS score tells you what the customer thinks after experiencing the service or product. Companies need to develop systems that ensure the service or product is exceeding expectations.

A great example is the Ritz Carlton’s policy whereby any Ritz-Carlton employees can spend up to $2,000 per incident, not per year, to rescue a guest experience. This policy ensures that the customer is getting a great experience because it empowers employees to fix problems and provides the customers’ concerns are solved quickly. As David Marquet says, “Move the decision making to where the information is.” That is what Ritz is doing, and it is empowering employees and making customers happy.

Companies that have outsourced many functions to cut costs, so any customer has difficulty reaching the people they need or have to spend five minutes going through a phone tree to contact some is already failing at this.

Ensure your business model tracks customer satisfaction and you have ways to ensure that customers are happy.

 

Finance

Kaufman defines finance as “Bringing in enough money to keep going and make your effort worthwhile.”

As I have pointed out, this is key, and many people don’t realize the situation because of flawed analysis and lousy modeling. However, the key for any organization must be a well-defined “Profit/X.”

Many organizations don’t have a well-defined Profit/X, but there is a lack of discipline that ensures good financial performance without it. Profit/X is some unit of scale, and profit can be gross profit, net profit, EBTIDA, or EBIT. Examples that I have seen are:

  • profit per airplane
  • profit per job
  • profit per customer
  • gross margin per delivery
  • profit per employee

There is no correct Profit/X, just the one that works with your business. One organization that did deliveries chose Gross Margin/Delivery, which focused on reducing the cost of delivery to maximize profit. Once Profit/X is selected, the entire organization must seek to meet or exceed it; thus, everyone needs to understand it and how they drive it. With that focus and discipline, the organization is more likely to meet its financial goals and objectives.

 

Summary

In summary, the organization needs to be able to define its business model by the following:

  • Define the problem its products or services solve or, more precisely, what job they do.
  • Who their Core Customer is so they can market to them effectively?
  • What is their brand promise, and how is it measured?
  • That their customers are satisfied, returning and recommending.
  • That they have identified their Profit/X so that they are profitable.

Doing this work is an excellent exercise for any leadership team to help bring clarity to your organization. If you need assistance doing it, contact me. Good luck, and may your business grow.

 

 

Copyright (c) 2021, Marc A. Borrelli

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Right out of the gate, I will admit I stole the “Flaw of Averages” from Sam Savage, whose book by that name I cannot recommend highly enough if you find this topic of interest.

What is my issue with averages? They misstate what is happening in the business and cause misallocation of resources. Let’s take a hypothetical business, ABC Inc., with the following products, units sold, unit price, and gross profit per unit. Now while this examines Products, we could easily substitute Services.

Product

Units Sold

Price/Unit

Gross Profit/Unit

A

         30,000

 $          100.00

 $       12.50

B

           7,500

 $            90.00

 $       75.00

C

         20,000

 $            80.00

 $       37.50

D

         15,000

 $            70.00

 $       45.00

E

         10,000

 $            60.00

 $       25.00

F

         25,000

 $            50.00

 $       12.50

G

         20,000

 $            40.00

 $       20.00

H

         20,000

 $            30.00

 $       25.00

I am sure that everyone can see that ABC’s revenue is $9,575,000 and its gross profit is $3,825,000, giving it a gross margin of 39.9%. Let’s assume that this gross margin is in line with the industry to not get into the cost of goods sold issues.

If we look at products in terms of revenue and sort from largest to smallest, we get the following.

Product A is the largest seller accounting for about 40% of sales. While products B, G, H, and F together account for 35% of sales, obviously less than A. So, how should we consider this product portfolio?

Examining the product portfolio, we see that A accounts for only about 10% of gross profits. Products B, G, H, and F together account for 46% of gross profits, so they are far more critical to ABC’s profitability. Furthermore, products C, D, B, H, and G are more important than the revenue chart above would indicate. While they account for about 50% of revenue, they generate 75% of gross profit and have a gross profit margin of 61%.

If ABC were to stop selling product A, its revenue and gross profit would fall by $3MM and $300k, respectively, and its gross profit margin would increase from 40% to 52%. Increasing gross profit margin by over 10% would be fantastic! Furthermore, given product A’s high cost of goods sold, we can assume that it is consuming a large amount of raw materials and labor–in other words, working capital. If ABC were to stop selling A, its working capital situation would improve, thus improving its liquidity ratios.

Also, this simplistic assumption doesn’t provide details, but there are possibly additional costs that I have not included from the production of A, namely:

  • Factory space to produce A
  • Warehouse space to store the raw materials for A and completed inventory.
  • Staff to track orders and purchases related A
  • Shipping costs of A
  • Staff overseeing the production of A

If ABC were to stop producing A, it’s Selling, General, and Administrative Expenses could fall further, boosting profitability. Thus, by looking at average margins, we don’t see Product A’s full impact on the business. Now I realize that A might be essential to getting the other products’ sales, but undoubtedly, we can increase the price of A or put together a bundle for more effective pricing.

Many years ago, when I was working at Holiday Inn, now IHG, the company was delighted with Holiday Inn Express’s launch. Holiday Inn Express franchises were selling like proverbial “hotcakes,” compared to the sale of old Holiday Inn franchises (“Green Sign” as we referred to them then). The increase in franchises was boosting distribution dramatically. However, if we look further into this and add some data (the numbers below are indicative, not actuals, to show the effect), we see it is not as straightforward.

 

Holiday Inn

Holiday Inn Express

Avg No of Rooms

120

80

Average RevPAR*

$48

$35

Franchise Fee

7%

6%

Expected Hotel Revenue ($ 000’s)

2,102

1,022

Expected Franchise Income ($ 000’s)

147.2

61.3

Franchise Support Costs ($000’s)

20.0

50.0

Estimated Profit ($000’s)

127.2

11.3

RevPAR = Revenue per Available Room = Revenue / Rooms

So, while Express hotels were selling faster, IHG needed to sell two Express hotels for each Green Sign. Also, most Express hotels buyers were independent operators who had not owned franchised hotels before if they had even held a hotel. Owners of Green Sign hotels were typically experienced hotel owners who often owned multiple properties. Due to the clients’ difference, further analysis showed that each Express owner required 2.5x the Holiday Inns’ franchise service support. Thus, while Expresses were selling like hotcakes, the profitability was far lower, and it is easy to see how the adage, “We lose money on every sale but will make it up in volume,” happens.

If we add customers to the mix makes it gets more interesting. Let’s assume ABC has the following customers, who purchase the following amounts of product.

Now, if we examine the purchase and gross profits of each customer, we get:

Customer

Revenue

Gross Profit

S

1,899,890

        869,085

T

       1,725,700

          700,983

U

       1,598,430

          414,600

V

          951,540

          491,173

W

       1,273,760

          459,958

X

          563,430

          259,640

Y

          458,530

          176,880

Z

       1,103,720

          452,683

Total

9,575,000

     3,825,000

Sorting that into the order of gross margin, we can see the following:

,Now we can see that S is our most profitable customer by a large margin, and the gross margin from its purchases is above ABC’s average. Hopefully, every company has done this analysis and know that they all want customers like S.

However, if we look across the rest of the clients, X, while not generating a lot of profit, does so at a very high margin. Y generates slightly less profit but at a margin below 20%. So, ABC wants more customers like X and fewer like Y. Also, given that our average gross margin was 40%, nearly all customers except Y, W & U are buying combinations to generate gross margins above 40%.

Therefore, this analysis shows that while ABC’s gross margin is nearly 40% and its gross profit is $3.8MM, if it were to lose customer S, sales and gross profits would fall to $7,675,110 and $3,333,828 respectively, providing a gross margin of 38.5%. However, if ABC were to lose client U, sales and gross profits would fall to $7,976,570 and $3,410,400, respectively, while gross margin would increase to 42.8%. Increasing gross margin by even 300 basis points would be significant for many companies.

As with products, we don’t see which clients to seek or replace by looking at the average gross margin. If ABC were to extend the analysis to clients that were done product A by looking at the time taken to service each client, it might find more that are not worth having.

(An old client of mine had a business doing about $4MM in revenue and generating $200k in EBITDA. His original client, say XYZ, was his largest, accounting for 40% of his sales, and it was time for the contract renewal. As we looked at it, we noticed that XYZ was like Product A, generating meager gross profit. We then analyzed what would be the impact on the business if he were to lose XYZ. My client realized he could cut his workforce by 50%, reduce his vehicle fleet by 55%, and cut energy consumption and floor space. As a result, he held firm on his proposed price increase with XYZ during the contract renewal, and XYZ refused to renew the contract. So, he cut the expenses we had identified, and the following year, his revenue fell to about $2.4MM, but his EBITDA increased to $450k.)

Finally, for company ABC, when we determine that we want to make a gross profit of “X%”, focusing on each product to ensure it meets that criteria will help. By focusing on each customer to ensure that their purchases don’t drive gross profits down, we can raise ABC’s profitability.

I hope you do this work for all your products/services and clients regularly and focus on those that improve margin and profitability. Using data properly can really help your business.

As I mentioned above, if you are interested in this area, I would recommend the following books The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty, by Sam Savage and Why Can’t You Just Give Me The Number?: An Executive’s Guide to Using Probabilistic Thinking to Manage Risk and to Make Better Decisions, by Patrick Leach.

 

Copyright (c) 2021, Marc A. Borrelli

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