By Dr. Peter Turney
CEO, Cost Technology

Make  Decisions That Count

Good managers focus on developing and implementing successful strategies. They don’t take high performance for granted. They ask the right questions, test the best ideas, and make only those decisions that are proven to improve the bottom line.

Testing and adopting the best ideas is dependent on use of performance tools and the quality of the analysis using these tools.  Some organizations lack a culture and tradition of fact-based analysis and decision making. Others rely on outmoded approaches to decision making that are inaccurate and may result in missed opportunities or decisions that appear profitable but in reality reduce the bottom line. Our experience shows that the “profit gap” left on the decision table is 400% or more of current profits.

The Five Steps to Profitable Decisions

1.      Identify the top sources of increased profits

The first step is to identify the biggest potential sources of increased profit. These are the areas where good decisions count. Specific areas for each company will vary depending on the nature of the business, current business performance, competitive conditions, and the strategic direction of the business. They include lines of business, market segments, channels of distribution, customers, product mix, pricing, marketing initiatives and buckets of cost.

In some cases the areas of greatest decision impact will be easy to identify. High level analysis of current performance versus strategic goals will find some obvious targets. This analysis can be done very quickly. If information is required to pinpoint action areas, more analysis is necessary. This additional analysis will reveal hidden opportunities to increase profits. For example, a high level profitability model can reveal market segments that are destroying profits. This profitability model can be built in 60-90 days and may lead to immediate decisions that increase profits.

2.      Evaluate how decisions are made

Effective decision making is dependent on the sources of decision information and the ease of making decisions using this information. It is heavily influenced by the use of performance measures to guide and reward decisions.

If the primary (or exclusive) source of financial information is the accounting system, decisions will likely result in significant profit destruction. This is because the primary purpose of an accounting system is financial reporting. Accounting was not designed to provide information about the sources of profits. Here are some examples of the negative impact on decisions:

• Decisions on product and service mix and price are affected by inaccurate and incomplete product costs. This is because manufacturing companies use standard costs as the measure of product cost, and standard costs are notoriously inaccurate. Service companies are not required by generally accepted accounting principles to have product costs, so often have no cost measures to use in decision making. 
• Except in aggregate, financial systems do not report the cost of market facing activities such as customer acquisition, advertising and channel support costs. Decisions regarding market segments, channels and customers therefore lack relevant cost information. Customer relationship management (CRM) systems include lots of information about customers, but usually do not report the cost to serve each customer or customer group. 
• Financial systems report cost by account by not by process or objective. Accounts—such as depreciation, salaries, office supplies etc.—provide no information about the state of the underlying business purpose. If salaries are decreased in an effort to improve profits, will this benefit the business or hurt the business? Does spending contribute to the accomplishment of strategic objectives? It is not possible to answer these questions using cost information from the financial system.

The ease of making decisions is dependent on the availability of decision tools and timely access to decision information. For example, in a company with several distribution centers, an important decision is the choice of the distribution center to serve a particular customer. This complex decision may involve manufacturing costs, shipping costs, material handling costs, taxes and tariffs, and the costs of meeting customer requirements. In the absence of an optimization model that takes each of these cost elements into account and determines the correct solution, it will be difficult if not impossible to determine the lowest cost alternative.

Difficulty obtaining information can have a negative impact on decisions. Relying on out-of-date information in a rapidly changing business environment may result in the wrong decision. Delays obtaining information will lengthen the time it takes to make a decision, increased analytic effort will increase cost, and decisions may be made by necessity without the insights derived from the information.

3.      Close the decision gap

Closing the decision gap, and focusing decision outcomes on profit improvement, requires ready access to decision relevant information and tools. Such a system typically includes cost and profitability management models, decision analysis and optimization tools, and desk top access to up-to-date relevant information and tools. 

Cost and profitability models are designed to report the exact information needed to make critical profit enhancing decisions. They differ from financial accounting by their use of activity-based costing (ABC) modeling techniques and scope of analysis. They also leverage the billions of transactions in computer systems to create a rich repository of cost and profit information. When fully automated using data integration tools, these models allow decision makers to focus their time on decision analysis rather than data entry and spreadsheet manipulation

Decision analysis and optimization tools help decision makers derive meaning from the information in the cost and profitability models, and determine the decision outcomes with the highest likely profitability.  For example, using analytics it is possible to determine which customers are the most profitable over an extended period of time and when adjusted for risk. Based on this analysis, marketing initiatives for customer acquisition and retention and up sell can be targeted to these profitable customer groups.

Desk top access to decision relevant information and tools increases the impact of decisions on profitability. In such a system each decision maker uses a portal to access the information he or she needs for decision making. Standard reports, refreshed to reflect the most recent information, are supplemented by queries into the profit information data bases to combine and report specific types of information. Projections of profitability, pricing models, cost minimization and other optimization techniques are available as needed from the portal.

4.      Change the performance measurement system

In a perfect world managers would automatically change their approach to making decisions based on the availability of information about the sources of profitability and use of decision making tools. In reality, lack of enthusiasm for analytic approaches and inappropriate measurements may be barriers to adoption and execution.

Analytic approaches to decisions that focus on profitability benefit from management commitment. Sometimes this comes down to culture—some organizations are immersed in fact-based decision making, while others follow a more intuitive approach. If top management incorporates analysis in key decisions, it is likely that the rest of the organization will follow their example.

The availability of information about the sources of profitability will not be enough if managers are evaluated and rewarded based on non-profit measurements.  For example, one company implemented a profitability management system but found that sales did not use the system to determine what to sell and how to price the product. This was because the sales force was compensated based on sales revenue.  A change to compensation based on net profit margins saw an immediate response, with product mix changing dramatically in the month following the change.

Adding objectives and measures of profitability to scorecards is a great way to focus attention on making profitable decisions. In a balanced scorecard, measures of customer, segment and channel profitability can be added to the customer dimension. Measures of cost can be added to the process dimension to focus cost improvement efforts. The balanced scorecard also helps focus decisions on improving long-term profitability rather than actions that favor short term profits.

5.      Track the results

It is important to measure the success of profitability management. Tracking results reinforces the emphasis on fact-based decision making and the positive impact of decisions on the bottom line. It also encourages improvements to the profitability management system to strengthen the program.

While it may not be possible to track the impact of every decision, it is feasible to measure the success of the key profit initiatives that account for 80% or more of the improvements in profitability. What was the increase in segment profits resulting from a new negotiating strategy using accurate measures of customer profitability? What was the return from investing in customer retention activities? What were the cost savings from replacing vehicles in the fleet based on minimizing the lifetime cost of equipment ownership? The returns from these and other initiatives can be accumulated to provide an overall measure of success of profitability management. For most companies the return will be significant.

Conclusion

Twenty five years of research and implementation of profitability management systems confirms that many companies have hidden pockets of unprofitability and profit opportunity. With the right information and tools, and systems to support and motivate profitable decision making, it is possible to increase profits by 400% or more. This increase is derived from making smarter decisions. It is possible without the heavy lifting and cost associated with initiatives to increase sales or reduce costs.

There are five proven steps to smarter and more profitable decisions. The first step is to understand where the profit increases will comes from and focus efforts on those areas. The second step is to assess how decisions are made and identify gaps in the type of information and tools that are used to make decisions. The third step is to implement a profitability management system that makes it possible and easy for managers to find and exploit the hidden opportunities to increase profits. The fourth step is to bring the performance measurement system into line with the new emphasis on profitable decisions, providing managers the motivation to make decisions that increase the long-term profitability of the company. The fifth and final step is to score the results of the new profitability management system and decision emphasis. This reinforces the success of the program and provides impetus to continue and improve profitability management.