All management teams aim to position their organization to withstand the ups and downs of a business cycle while maintaining its ability to thrive. The key to achieving that goal is to sustainable success and optimize profit targets. While most firms make an effort to optimize profits, I’ve discovered that when those efforts fail, it’s because they lack a robust framework for creating the correct targets or a strategy for achieving their objectives.
Establishing this kind of structure is especially vital when economic trends are bleak. A possible recession may cast doubt on planned sales growth and cash flows. Inflationary pressures raise labor, material costs, and operating expenditures, decreasing profitability unless they are quickly addressed with price hikes or other mitigating measures. Higher interest rates tighten the screws even further, reducing return on invested capital, particularly for companies with unhedged floating-rate debt commitments.
That does not mean it is time to panic. Challenging times provide an sustainable success opportunity for leadership to prevent financial distress by reviewing company processes, vendor agreements, product portfolios, pricing, and other factors to streamline operations and develop strategies that deliver optimal margins while allowing the business to achieve key objectives. With resources distributed as efficiently as feasible, management can respond quickly and boldly in the face of headwinds. And, if a recession does not occur or other patterns improve, your company will be better positioned to capitalize on new growth opportunities.
In this post, I will explain a four-step strategic strategy that organizations may utilize to successfully identify and implement profitability optimization strategies in the face of rising inflation and interest rates. I focus on EBITDA margins to exclude the noncash impact of depreciation and amortization, which are less affected by profitability initiatives.
Define Optimal Profitability and Establish Targets
Yogi Berra once famously observed, “You’ve got to be very careful if you don’t know where you’re going because you might not get there.” Once you’ve untangled this guidance, it applies to any strategic planning. When dealing with profit optimization, management must avoid projects that generate short-term gains at the expense of long-term strategic goals.
Frequently, I see management teams create targets without fully understanding their company’s potential. Traditionally, you would evaluate past data to determine future profitability targets; however, this can lead to underestimating your organization’s potential. Historical data alone cannot tell you everything about your company’s capabilities, especially if conditions change, or whether your company’s previous performance is sustainable in the long term. If you solely consider what you’ve done in the past, you may set a goal that is much below—or worse, exceeds—what you are capable of achieving.
For example, a company’s management may see that the business has an average EBITDA margin of 13% during the last three years. Margins fell to 9% this year, owing in part to external circumstances. Management takes the initiative to restore EBITDA margins to 13% by setting goals based only on historical data.
While this method may help to sustain the firm, return to previous profitability levels, or even attain new levels of profitability, it does not identify the full potential for EBITDA margins. Opportunities to achieve 15% or 17% margins may exist, but the company will never reach them unless its management realizes what is achievable. Over time, these percentage points will be worth millions of dollars to investors. Let’s look at what you should do instead of depending entirely on past facts.
Looking at the example below, we can see that the (creatively called) ABC Co.—a fictitious HR and payroll software company—has an EBITDA margin of 15%, compared to a historical five-year average of 13.5%. However, ABC Company’s leadership should not be complacent.
Individual company data for competitors, as well as other industry and market research. Can be used to calculate industry average EBITDA margins and margins for similarly sized companies. This information is freely available for public firms; however, for private companies. It may only be obtained through a subscription service such as D&B Hoovers, IBISWorld, or PitchBook. If your company is having trouble getting this information or locating high-quality data. A skilled finance and strategy consultant can assist by providing benchmarking data and doing a full analysis with actionable results.
According to an IBISWorld study, ABC Co. has best-in-class EBITDA margins in its industry. Which is over 28%. At this point, ABC Co. can create a few benchmarking scenarios to determine its own optimal EBITDA margin—best in class, high performer, industry average, or comparable to an average similarly sized company. With this information at hand, management may begin evaluating performance against these criteria to see which one is attainable.
Assume ABC Co. management has developed the following benchmarks to measure the company against and set the accompanying targets. These benchmarks compare ABC Co.’s current performance to the best in class, top performers, the industry average, and the average of similar-sized organizations. When conducting this exercise, you should set benchmarks that follow a similar rationale.
ABC Co. management can see that it lags behind the industry average in all margin parameters. With the exception of gross margin and operating margin, which are slightly higher than the norm for like-sized companies. ABC Co.’s leadership, like any other management team, strives for best-in-class performance. However, they believe that initially aiming for best in class will be a daunting endeavor for their employees. So they resolve to carry out the optimization process in iterative increments to avoid burnout. Following a discussion about the organization’s current situation and the types of improvements that appear doable based on current capabilities. They decided to focus on the high-performer EBITDA margins benchmark first.
Sustainable Success Identify Levers to Optimize Profitability
With benchmarks and targets defined, sustainable success management can proceed to the following step in the strategy development process: establishing the operational levers that will lead to the desired results and then sanity-testing those targets.
Based on my experience with numerous customers, I understand how tempting it may be for leadership to focus on lowering operating expenses and implementing cost-cutting initiatives as a means of improving profitability. Undoubtedly, operating expenses and efficiency are important considerations in any overall strategy. However, management is doing the firm a disservice by ignoring the role revenue and gross margins can play in profit maximization, as there may be considerable potential to improve the product range, pricing strategy, or cost of sales. These innovations have the potential to significantly increase EBITDA margins.
Regarding the income statement, I prefer to use a top-down approach to discovering operating levers, with revenue being the first item reviewed. The guiding questions at this stage of the process should be:
Which of these variables does management have the most control over?
Which of these elements can assist management in differentiating the business and getting a competitive advantage?
While individual responses vary for each company, the most significant elements often come from the following areas:
Product offerings: Evaluating product offerings might uncover chances to improve gross profit margins. Which will be passed on to EBITDA margins. Product mix, product quality, unit price, return rates, product uptake, and successful cross-selling or upselling are all important variables to examine.
Sales operations: These metrics may reveal possibilities to improve the sales process. As measured by units sold, higher margin units sold, shorter sales cycle times, and higher win rates on closed agreements.
Customer happiness is sometimes disregarded because it does not appear directly on the revenue statement; nonetheless, net promoter scores, customer reviews, customer turnover, and average yearly customer care calls per customer are important indications. However, customer happiness is crucial to profit maximization. Having highly pleased customers leads to reduced levels of churn and returns. More frequent repeat purchases, and favorable word-of-mouth marketing, which reduces client acquisition costs, among other benefits.
Operating efficiency is the major objective of most profit optimization efforts, but it should never be the sole one. There is always a chance to increase efficiency and save operational costs. Operating expense ratios, employee pay as a percentage of revenue, revenue per dollar of wages, and return on ad spend are some examples of indicators to consider. There will be several potential for improvement across various businesses. For example, manufacturing companies can examine throughput, machine downtimes, cycle times, and utilization, while financial services companies can review loan processing times, fraud detection, and customer churn. These areas of focus provide an all-encompassing evaluation of organizational performance and the factors that influence operating margins.
ABC Co. conducted internal and external benchmarking and provided the following report, which details some of the factors of EBITDA margin success. As we can see, the evaluation takes into account internal, rival, and industry performance.
As you can see, ABC Co. has unearthed key insights that will assist guide its future margin expansion strategies. Here are the primary action items that emerged from this analysis:
Improve communication of product value, as seen by the low number of customers who purchase subscriptions following a free trial.
Improve price strategy, as evidenced by competitive pricing and a low revenue per dollar of labor statistic.
Sustainable success improves sales training and practices, as evidenced by longer sales cycles and stagnating average deal prices, which will reduce margins.
Improve customer experience and satisfaction, as evidenced by high customer churn rates and negative consumer sentiment expressed in reviews and feedback.
Also improve organizational structure, commission programs, and other types of remuneration. As well as workplace culture, sustainable success which is characterized by poor revenue per dollar of wages and significant staff turnover.
Sustainable Success Sensitize and Prioritize Margin Improvement Initiatives
After identifying the most significant areas of opportunity, the next step is to conduct a sensitivity analysis to determine. Which of these poses the most risk to EBITDA margins and offers the greatest possibility for improvement. This study enables management to begin building a strategy to address the gaps and increase margins. While it would be ideal for the company to focus on all areas for improvement at the same time. This may not be feasible in practice. Prioritizing efforts is critical for devoting resources to the most effective activities feasible.
Consider the following considerations for each improvement opportunity:
The level of control that management has over the opportunity
How long it will take to make a change that has a major impact on margins?
What it will realistically take to reach the highest potential improvement, considering the most probable scenario
How much does each metric affect margins?
In my opinion, the easiest method to approach this work is to create a dynamic operating model in Excel. That includes the primary drivers of performance as independent variables that feed the rest of the model. Developing an operating model is beyond the scope of this article. I will point out that treating important operating levers as independent variables allows management to measure the impact of each variable separately. Establishing its sensitivity to EBITDA margins and revealing the most important initiatives.
Continuing with the example: After selecting the operating levers (independent variables) and completing the model. ABC Co. management estimated the exact sensitivities listed in the table below. The sensitivity calculation computes the percentage change in EBITDA margin for each 1% improvement in each of the selected operating levers. Historical data and the relationship between individual operating levers and EBITDA margin can help provide further context.
As can be shown, increasing the percentage of consumers that subscribe to the company’s premium software product has the greatest impact on EBITDA margin. A 1% increase in sales mix results in a 0.5% gain in EBITDA margin. However a 1% increase in customer growth or decrease in customer acquisition costs result in only a 0.1% rise in EBITDA margin.
With sensitivities defined, the next step is to calculate the greatest predicted improvement for each of these initiatives. Keep in mind the previously mentioned considerations: the degree of control and the implementation timeline. For the sake of simplicity, we’ll assume that all prospective initiatives have identical timetables. And that advances in one area will benefit others, compounding the effect on margins. (For example, lower customer churn suggests higher customer happiness. Which can help minimize client acquisition expenses and lead to improved customer growth.)
Using revenue per dollar of labor as an example, a 1% increase leads to a 0.4% margin enhancement. Some options for increasing this metric are:
To increase sustainable success revenue, subscription costs for new consumers are being raised while existing customers are grandfathered in.
Improving the mix of premium subscription sales to boost income.
Revising the commission structure to better match sales incentives with strategic goals.
Reducing staff turnover and associated costs.
There are numerous other choices; the idea is that performing this procedure for each effort enables management to apply an expected range of outcomes and prioritize its selections. ABC Co. generated the following results after determining the best-case, base-case, and worst-case situations for each of its efforts.
Assuming these were new projects, ABC Co. executives assigned a subjective weight to each possibility based on their assessment of its plausibility. If you have historical data from previous projects. It can also be used to determine the weights allocated to each case.
ABC Co. management was able to calculate a projected EBITDA margin improvement for each highlighted initiative by taking the weighted average of each scenario. Because we believed that time and degree of control are irrelevant in this scenario. The activities were sorted from most effective (premium sales mix) to least impactful (customer growth).
Sustainable Success Communicate and Implement
After defining and prioritizing the objectives, sustainable success management must communicate the plan of action to the rest of the organization and begin implementation. This necessitates the same level of care and organization as previous endeavors. Without the proper communication strategy, resources, and capabilities, even the best-defined strategies will fail.
Here are the components to prioritize.
A well-defined project hierarchy fosters accountability and generates a line of communication and decision-making, which improves efficiency. Clearly defined duties enable management to identify bottlenecks and act promptly to implement solutions.
Open and transparent communication is a fundamental management principle that is generally relevant outside of profit improvement activities. Explaining the project’s strategy and expectations in an organized. A transparent manner promotes a sense of ownership and buy-in among the people tasked with carrying out the plan. Furthermore, encouraging input and employee engagement might uncover new, imaginative solutions that management might not have explored otherwise.
Formal progress evaluations: Periodic reviews communicate the importance of the effort to staff. A lack of managerial attention will lead to a lack of employee focus, resulting in stagnation and failure.
These efforts require tremendous resources and support. It is critical to be able to adjust the strategic strategy and pivot swiftly. New processes or tools may need to be created or implemented. Management must commit to providing. Whatever is required for the team to accomplish the anticipated margin growth; otherwise, the project will fail.
Conclusion
Using the four-step approach discussed in this sustainable success article. Your firm will be able to successfully create a thorough sustainable success profit-optimizing strategy. Best of all, this may use as an iterative tool to assist multiple rounds of profit optimization campaigns until you reach your desire results.
The advantage of this technique is that it finds the most effective levers for increasing profitability. Which may go beyond just lowering operating expenses. Allowing management to allocate resources effectively and move fast and confidently. Once the optimization process begins, the processes provided in the implementation stage assist management in identifying and addressing difficulties.
I advocate including this sustainable success profit optimization exercise in your organization’s annual planning process to maintain priorities up to the present. If an economic slump occurs, your firm best position to weather it. Without a downturn, your firm better position to make smarter investments in growth efforts. In any case, your sustainable success organization will prepare for whatever the future may contain.
