Analyst Perspectives

In anticipation of conditions that suggested accelerating price increases, I wrote in 2021 about how technology could be useful in an inflationary period, anticipating the world we live in now. Responding effectively to changes in costs is always challenging, but even more so because of the choppy and chaotic nature of the current environment. Inflation may have abated from its highs throughout the rich world but is still an important factor in business decisions. Many enterprises have limited or no ability to raise prices and are forced to find ways to minimize the impact of rising costs. And while it’s true that some organizations have a degree of pricing power, behind this generalization is a more complex reality because this ability to raise prices varies depending on specific products, customers and channels. Companies can best address the challenges of inflation by adopting a technique that ISG Software Research calls “profitability management.” 

Profitability management goes beyond setting targets. Most companies manage to profitability objectives: CEOs are accountable for meeting company-wide financial objectives, including return on equity or return on assets, because investors use these in assessing the financial health and attractiveness of a business. In turn, they assign responsibility for achieving profitability to business unit owners across and down an organization. Sales quotas are put in place to achieve revenue goals are, and budget owners have cost and margin objectives. However, this is not the same as profitability management.

Profitability management is a software-enabled discipline that’s especially useful in today’s rapidly changing market conditions. In an inflationary environment, sellers must be able to quickly adapt by having a full understanding of the true economic costs of products, the cost to serve customers and to operate channels. An enterprise must be able to make pricing decisions that enable it to successfully execute a go-to-market strategy. Because revenue recognition and stock-based compensation can distort measures of economic profitability, chief financial officers must have an appropriate set of lenses through which to view targets and results simultaneously from multiple perspectives. Profitability management is not simple, which is the reason it can be a source of sustainable competitive advantage.

From an organizational perspective, profitability management poses challenges because it is a cross-functional effort that integrates finance and sales to achieve an optimal balance of revenue and margin objectives. This is a more effective performance management tool because it is a data- and analytics-based approach designed to consistently achieve higher sales and fatter margins. ISG Software Research asserts that by 2026, just 35% of enterprise financial planning and analysis teams will deliver actionable customer and product profitability analysis. Finance departments that do will be a strategic asset.

A profitability management initiative involves parallel efforts by the Office of Finance and the sales organization. The first, handled by financial planning and analysis, requires setting up and running a profit analytics program. These analytics provide the rest of the organization with consistent and reliable detailed information about product, customer and channel profitability to support better decisions about pricing, product bundling, sales quotas, incentive compensation and production.

The second supports a price and revenue management structure in the sales organization that achieves an optimal trade-off between revenue and margin. Organizations that use software to gain better insight into a buyer’s willingness to pay can set the highest possible price in a transaction with the greatest likelihood of getting the business. They also use software to identify potential cost reductions or find ways of disaggregating offerings (for instance, separating handling and shipping charges).

Profitability management uses an analytics-driven business discipline designed to enable enterprises to achieve superior market share and profitability objectives. At the heart of the challenge is the ability to quantify the profitability of specific products, customers and channels and every permutation of these. That does not happen in most companies today. Our Office of Finance benchmark research found that only 34% manage customer profitability, and just 30% of companies manage product profitability.

Profitability is determined by revenues minus costs, so it is axiomatic that organizations must fully understand the true economic costs of products, customers and channels. The enterprise must then use these insights to make decisions about pricing, marketing, quotas, territories and incentive compensation. Both efforts rely on software to deal with large data sets and often complex analytics to achieve the best results in dynamic market conditions.

Economic costing is a better approach than financial accounting measures for understanding profitability. Statutory accounting is designed for financial—not operational—management. Accounting costs can be abstract and divorced from economic costs and cash flow. This includes generally accepted accounting principles for revenue recognition and equity compensation. Financial accounting suffers from basic analytical issues such as the sunk-cost fallacy. Economic costing is often a better way to determine the profitability of serving a specific customer or class of customers, as well as the cost to serve a specific channel or geography. Enterprises with a deeper, more economically accurate understanding of all costs are better able to control them. In being able to control them, costs can be managed in a way that is consistent with organizational strategy, resources and market position.

Revenues are a function of units sold times the price per unit. Setting that price can be challenging. The most straightforward and longstanding approaches to price setting are a cost-plus calculation or just charging what competitors are charging. More recently, though, demand-based pricing has achieved a following because technology makes this approach practical. Demand-based pricing uses an estimate of the perceived value to the buyer of a good or service as the central element in setting prices. Demand-based pricing enables an enterprise to reliably achieve higher revenues and higher margins than other approaches because it is based on the buyer’s willingness to pay. Charging more when the buyer is willing to pay produces higher profits without sacrificing revenue and market share.

At the heart of demand-based pricing is a price and revenue-optimization technique that uses market segmentation to achieve strategic objectives such as increased profitability or higher market share. Price and revenue optimization has demonstrated repeatable results. It first came into wide use in the travel and hospitality industry in the 1980s. It enabled hotels and airlines to maximize returns from less flexible travelers, such as people on business trips, while minimizing the unsold inventory by selling incremental seats on flights or hotel rooms at discounted prices to vacationers.

Ideally, cross-functional initiatives such as profitability management are led by the CEO, whose involvement and commitment are necessary to mediate with authority the inevitable differences between conflicting objectives and constraints. If the initiative does not spontaneously come from the CEO, I suggest the CFO should be a champion. This individual should make profit analytics a top three priority and advocate the use of demand-based, intelligent pricing in the leadership team.

I recommend that every finance organization—and specifically the FP&A group—routinely measure customer, product and channel profitability using an economic costing method to do the analysis. This is most effective when done as part of a coordinated cross-functional effort. The sales organization, the sales operations team and/or a pricing group manage and review the pricing of products, services and contracts. Marketing creates campaigns and offers, which need to be tied to revenue and profitability objectives. And operations—whether manufacturing, services or fulfillment—must be involved to understand the nature of costs, constraints and other details.

It’s common to hear it said that business has never been more challenging. It’s a marketing line designed to grab your attention. In reality, business challenges never fundamentally change. Enterprises must offer customers appealing products or services, attract and retain the best talent, market and sell effectively, maintain financial control and so on. What does change are the tools—especially technology—that businesses can use to enhance competitiveness and improve performance. Technology—and the ability of some clever enough to use it to gain an advantage—is the real challenge. In inflationary times, profitability management is just such a tool that enables enterprises to outperform rivals.

Regards.

Robert Kugel