Analyst Perspectives

A year ago, I wrote about how technology could be useful in an inflationary period, correctly 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. Many organizations have a 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 there is a more complex reality because this ability to raise prices often varies depending on specific products, customers and channels. Companies can best address the challenges of inflation by adopting a technique that Ventana Research calls “profitability management.”

Most companies manage to profitability objectives: CEOs are accountable for meeting company-wide financial targets, and assign responsibility for achieving profitability levels to business unit owners across and down an organization. Sales quotas designed to achieve revenue goals are put in place, 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 organization must be able to make pricing decisions that enables it to successfully execute a go-to-market strategy. Profitability management is not simple, which is the reason it can be a source of sustainable competitive advantage.

From an organizational perspective, profitability management 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. Ventana Research asserts that by 2025, one-third of organizations will implement a profitability management initiative.

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 organizations 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 three. 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 have a full understanding of the true economic costs of products, customers and channels. The organization 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. Financial accounting suffers from basic analytical issues such as 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 for a specific channel or geography. Organizations that have a deeper, more economically accurate understanding of all costs are better able to control them. And 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 charge 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 a good’s or service’s perceived value to the buyer as the central element in setting prices. Demand-based pricing enables a company 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 that 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. Within the sales organization, the sales operations team and/or a pricing group manages and reviews 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 it is manufacturing, services or fulfillment —must be involved to understand the nature of costs, constraints and other details.

The circumstances that businesses face are ever shifting, but business challenges never change. Organizations must offer customers appealing products or services, attract and retain the best talent, market and sell effectively, maintain financial control and so on. The real challenge with technology is finding ways for those clever enough to use it to gain an advantage. Profitability management is just such a tool for our times.

Regards,

Robert Kugel