Leaders intent on making smart business decisions insist on using leading-edge financial models and practices. Here are just two examples of innovative models that deliver profits and increase shareholder value.

When creating something new, executives are faced with difficult decisions because so little is known and so much has to be assumed. The approach normally used in planning for an existing line of business—extrapolating future results from past experiences—simply does not work.

The Reverse Profitability Model is an innovative alternative. Starting with the profit that will make a venture worthwhile, executives can then work backwards to identify the unit sales, pricing and cost structure needed to get there.

The approach has several important benefits. The model becomes a living guide to decision-making—providing continuous feedback as new facts become known. The result is a rigorous testing of assumptions—from development through launch, and then on to becoming a going concern. Executives are able to track the viability of their plans and create checkpoints before making significant commitments, periodically evaluating whether or not it is smart to move forward.

For most companies, a quarter to a third of its products produces the bulk of the profits, while another quarter to a third generates a loss. The same breakout holds true for the company's customers. Profitability can be significantly improved by identifying which products/customers are profitable and why - and then by managing different profit clusters appropriately. This requires a three-step process:

1. Sort into Profit Clusters
   
   
2. Determine Profit Drivers
   
   
3. Develop a Profit Management Process

Sort into Profit Clusters
Many businesses focus on revenue growth rather than profitability. As a result, high volume customers and products are viewed favorably, when in fact they may have low profitability or even generate a loss. Managing profitability means shifting the focus to operating profits instead of gross profits.

• First, establish a profitability database of transactions over the past one or two quarters that identifies the customer, product, transaction type, revenue and product cost.
  
 

• For a true picture of profitability, include all operating costs—general overhead and other indirect costs should be allocated. This approach will highlight the profit contribution of each transaction, especially those that generate a loss. A full-costing that sums to an "official published" number, which is operating profits, also ensures that all costs are captured.
  
 

• The database can be grouped into Profit Clusters (High or Medium Profit, Low Profit/Loss) by customer, product or transaction type. This step will isolate the big pools of profits and losses.
  

Determine Profit Drivers
Each Profit Cluster can then be analyzed to determine the principal factors that drive profits or losses. There are four major and three other Financial Profit Drivers:

Financial Profit Drivers Major Other   Sales Volume   Price   Variable Costs   Fixed Costs   Asset Utilization   Inventory Management   Cost of Debt

"Many companies believe the most effective way to build profitability is to reduce costs.   This is not true—pricing and sale volumes are both more important."

• Price changes have the greatest profit impact, between two and four times greater than any other financial driver.
  
 

• An increase in price goes directly to profits compared to increased sales volumes, which only improve profits by gross margin.
  

Positive changes to the Financial Profit Drivers are generated by improvements in one or more Non-Financial Profit Drivers including:

	Non-Financial Profit Drivers
		Productivity   Customer Satisfaction   Product/Service Quality   Employee Training   Employee Satisfaction		Product Innovation   Process Innovation   Market Share   Employee Safety

These Non-Financial Profit Drivers can be quantified and then managed to improve the profitability of each Profit Cluster.

The most important Profit Drivers are likely to be different for each Profit Cluster (and perhaps, for individual products and customers within a Profit Cluster). It is necessary to analyze each Profit Cluster separately to find the two or three Profit Drivers that will have the most favorable impact.

Develop a Profit Management Process
Profit management needs to be an integral part of a company's culture that makes profits everyone's responsibility. To create a sustainable profit focus, executives need to:

• Define and widely communicate the key drivers of profitability
  
 

• Create metrics for each driver
  
 

• Train management on how to drive the company's performance and profits based on these metrics
  
 

• Use the drivers and metrics to link strategies with accountability.
  

Because each Profit Cluster may have different Profitability Drivers and link to different strategies, the Profit Management Process should be applied to each Cluster.

For more information on using alternative concepts to evaluate business decisions for improved profitability contact: Michael Courtney at michaelcourtney@optonline.net.