profitability
The Coming Changes to Manufacturing
Recently, I spoke with someone on a team analyzing ways to “mitigate the risk of exclusive manufacturing in China” without fully divesting their business interests in a growing and potentially lucrative market. This bifurcation exercise got me thinking about how many other companies are evaluating their supply chain relationships, inventory management, and the predictability of their cost of goods sold.
In the mid-1990s, I had done a lot of work with the MK manufacturing software that ran on the Ingres database. Some issues were performance-related and fixed by database tuning; some were fixed by using average costs instead of a full Bill of Materials (BOM) explosion with dozens of screws in a window; but some were more interesting and more business-focused.
After NAFTA became law, one manufacturer built a facility in Mexico and started manufacturing a few basic but important parts. When I arrived as a Consultant, the main problem they faced was a reject rate of roughly 20% and additional related QA costs. My suggestion was to treat this part (a single piece of steel, like the rotor from a disk brake system) as a component and build in the cost of both scrap and QA. They could then benchmark the costs against other suppliers in an apples-to-apples comparison to determine if they really saved money. That approach worked well for them.
While that approach helped manage costs, it did not address the timeliness of orders or lead time required – important aspects of Just-in-Time (JIT) manufacturing. Additionally, it should be possible to estimate shipping costs by considering changes in petroleum costs or anticipated changes in demand or capacity.
Systems out there claim to estimate the cost and availability of commodities based on various global factors and leading indicators. It is tricky, to say the least, and we can’t anticipate an event like a pandemic. But companies that manage their inventory and production risk best will likely be the ones that succeed in the long run. They will become the most reliable suppliers and have increased profits to invest in further growth and improvement.
The next 2-3 years will be very interesting due to technological advances (especially AI) and geopolitical changes. Those companies that embrace change and focus on real transformation will likely emerge as the new leaders in their segments by 2025.
Shouldn’t Sales Forecasting be Easy?
Of course it should… or maybe not.
First, what are you measuring? The answer to this seemingly simple question is something that anyone with a sales quota should be able to succinctly answer, since this is what you are being paid on.
But context matters, too. People at different levels of the business are likely reviewing multiple forecasts for multiple reasons. So, the first rule is to never assume.
So, what are you measuring?
- Bookings – Finalized Sales Orders
- You have a PO, but has the deal really been closed? What else is needed in your business to finalize an order?
- Billings – Invoicing Completed
- This includes dependencies that may introduce unexpected delays and/or be outside of your control, such as a deal that bills on October 31st versus November 1st. Are they still part of the same period (October)?
- Revenue – An in-depth understanding of Revenue Recognition rules is key.
- How much revenue is recognized and when it is recognized varies based on a variety of factors, such as:
- Is revenue accrued or deferred? This is especially key for multi-year prepaid deals, or when services are packaged with software as part of the deal.
- Is revenue recognized all at once – such as for the sale of Perpetual Software Licenses? (even this is not always black and white)
- Is revenue recognized over time – such as with annual subscriptions that are ratable on a monthly basis?
- Is revenue based on work completed/percentage of completion? This is more common with Services and Construction. How is that percentage determined?
- Are there clauses in a non-standard agreement that will negatively affect revenue recognition? This is where your Legal team becomes an invaluable contributor to your success.
- Cash Flow – Is this really Sales forecasting?
- The answer is ‘no’ in terms of Accounting rules and guidance.
- But, if you have a start-up or small business, this can be key to “keeping the lights on,” in which case the types of deals and their structure will be biased towards cash flow enhancement and/or goals.
- How much revenue is recognized and when it is recognized varies based on a variety of factors, such as:
- Profitability – In this case, what expenses are factored in that offset revenue?
- Cost-Volume-Profit (CFP) analysis tends to be one of these exercises where you learn that there are often several takes on what is or is not a related expense.
When I was a VP running two global regions, I would meet with the CFO prior to the end of a quarter to discuss what mattered most for the coming quarter. Sometimes the goal was more upfront cash; other times, it was guaranteed multi-year revenue. Sometimes it could be both, and I would be authorized to provide additional discounts on prepaid multi-year deals. The goals would change based on our banking covenants (revenue, investments, cash on hand), investor goals, valuations, etc. I often tracked multiple goals at once for various reasons.
My advice is to work closely with your CFO, Finance Team, Sales/Revenue Operations Team, and Legal team to understand their goals and guidelines, then take that one step further by creating policies approved by those stakeholders and share the highlights with the Sales team to avoid any ambiguity around pricing rules, process changes, and expectations. Great communication and a common understanding of the goals and rules help you and your team win.
So, now the hard part is over, right?
It could be that easy if you have one well-established product, a stable install base, no real competitive threats, a steady, predictable growth or decline rate, and consistent pricing and average deal sizes. I haven’t seen a business like that yet, but I’m sure at least a few exist.
Next, what are you building into your model to maximize accuracy? Every product or service may be driven by independent factors, so a flat model that evenly distributes sales over time (monthly or quarterly) is likely to be inaccurate when you have royalty revenue or progress-based billings.
For example:
- One product line that sells perpetual licenses may depend on release cycles every 18-36 months to maintain a steady revenue rate, with peaks and valleys within that window.
- A second product line may be driven mainly by renewals and expansion on fairly stable timelines and billings. In this case, annual uplifts may be needed to maintain profitability.
- A third product line may be new with no track record and in a competitive space – meaning that even the best projections will be speculative and likely optimistic.
- Finally, services could be associated with each product line and driven by more dependent and independent factors (new implementations, upgrades, implementing new features, platform changes and modernization, routine engagements, training, etc.) How and when are the revenue and expenses recognized, and what impact could they have with related items sold with (or close to) that deal?
Historical trends are one important factor to consider, especially because they tend to be the things you have the greatest control over (i.e., they should not change that much). This starts with high-level sales conversion rates and goes down to average sales cycle, seasonal trends, organic growth rates, churn rates, and more.
Having accurate sales and customer data over time that can be accurately correlated is extremely helpful. But factors such as Product SKU changes, licensing model changes, new product bundles, etc., increase the complexity of that effort and potentially decrease the accuracy of your results. These self-inflicted issues are often introduced without considering downstream implications. Fun!
Correlating those trends to external factors, such as overall growth of the market, relative growth of competitors, economic indicators (inflation metrics like CPI, interest rates, foreign exchange rates, corporate indicators (profits, earns per share, distributions, various ratios, ratings, etc.), commodity and futures prices (especially if you install base tends to skew towards something like the Petroleum Industry), specific events, and so forth increases the complexity of the model but can add an extra level of accuracy.
The best case is that those correlations increase your forecasting accuracy for the entire year. In all likelihood, they provide valuable inputs that allow you to dynamically adjust sales plans as needed to ensure year-over-year success. But making those changes should not be done in a vacuum, and communicating the potential need for changes like that should be done at the earliest point where you have a fair degree of confidence that change is needed. Simple, eh?
Unexpected events will always negatively impact your forecasts and plans. Changes to the competitive landscape, reputational changes, economic changes, etc., can all occur quickly and with “little notice.” That is especially true if you are not actively looking for subtle indicators (leading and trailing) and nuances that highlight potential problems and give you time to do as much as possible to address them proactively. The best advice is to anticipate the unexpected and have a contingency plan!
Forecasting accuracy drives confidence, which helps you secure funding for new campaigns or initiatives. Surprises, even positive ones, are generally disliked because the results differ from expectations, which can fuel other doubts and concerns.
Confidence comes from understanding, good planning, helping everyone meet a quota, and supporting teams to do what is needed, when it is needed, to optimize the process. This also assumes you can determine whether deals are really on track and intervene with guidance before deals slip or are lost.
It may not be easy, but it helps drive companies to the next level through a predictable, sustainable growth trajectory. In the end, that consistency often matters the most to the owners and stakeholders of a business.
It’s not Rocket Science – What you Measure Defines how People Behave
I previously wrote a post titled “To Measure is to Know.”
The other side of the coin is that what you measure defines how people behave. This is an often forgotten aspect of Business Intelligence, Compensation Plans, Performance reviews, and other key areas in business. While many people view this topic as “common sense,” based on the numerous incentive plans you run across as a consultant and compensation plans you submit as a Manager, that is not the case.
Is it wrong to have people respond by focusing on specific aspects of their job that they are being measured on? That is a tricky question. This simple answer is “sometimes.” This is ultimately the desired outcome of implementing specific KPIs (key performance indicators), OKRs (objectives and key results), MBOs (Management by Objectives), and CSAT (Customer Satisfaction), but it doesn’t always work. Let’s dig into this a bit deeper.
One prime example is something seemingly easy, yet often anything but: compensation plans. When properly implemented, these plans drive organic business growth through increased sales, revenue, and profits (three related items that should be measured). This can also drive steady cash flow by closing deals faster and within specific periods (usually months or quarters) and focusing on models that create the desired revenue stream (e.g., perpetual license sales versus subscription license sales versus SaaS subscription sales). What could be better than that?
Successful salespeople focus on the areas of their comp plan where they have the greatest opportunity to make money. Presumably, they are selling the products or services that you want them to based on that plan. MBO and OKR goals can be incorporated into plans to drive positive outcomes that matter to the business, such as bringing on new reference accounts. Those are forward-looking goals that increase future (as opposed to immediate) revenue. In a perfect world, with perfect comp plans, these business goals are codified and supported by motivational financial incentives.
Some of the most successful salespeople are the ones who primarily care only about themselves (although not at the expense of their company or customers). They are in the game for one reason—to make money. Give them a well-constructed plan that lets them win, and they will do so predictably. Paying large commission checks should be a goal for every business because properly constructed compensation plans mean their own business is prospering. It needs to be a win-win design.
However, suppose a salesperson has a poorly constructed plan. In that case, they will likely find ways to personally win with deals that don’t align with company growth goals (e.g., paying a commission based on deal size but not factoring in profitability and discounts). Even worse, give them a plan that doesn’t provide a chance to win, and the results will be uncertain at best.
Just as most tasks tend to expand to use all the time available, salespeople tend to book most of their deals at the end of whatever period is used. With quarterly payment cycles, most of the business tends to book in the final week or two of the quarter, which is not ideal for cash flow. Using shorter monthly periods may increase business overhead. Still, the potential to level out the flow of booked deals (and associated cash flow) from salespeople working harder for that immediate benefit will likely be a worthwhile tradeoff. I pushed for this change while running a business unit, and we began seeing positive results within the first two months.
What about motivating Services teams? What I did with my company was to provide quarterly bonuses based on overall company profitability and each individual’s contribution to our success that quarter. Most of our projects used task-oriented billing, where we billed 50% up-front and 50% at the time of the final deliverables. You needed to both start and complete a task within a quarter to maximize your personal financial contribution, so there was plenty of incentive to deliver and quickly move to the next task. As long as quality remains high, this is a good thing.
We also factored in salary costs (i.e., if you make more than you should, you’re bringing more value to the company), the cost of rework, and non-financial items that benefited the company. For example, writing a white paper, giving a presentation, helping others, or even providing formal documentation on lessons learned added business value and would be rewarded. Everyone was motivated to deliver quality work products on time, help each other, and do things that promoted the company’s growth. My company prospered, and my team made good money to make that happen. Another win-win scenario.
This approach worked very well for me and was continually validated over several years. It also fostered innovation because the team was always looking for ways to increase their value and earn more money. Many tools, processes, and procedures emerged from what would otherwise be routine engagements. Those tools and procedures increased efficiency, consistency, and quality. They also made it easier to onboard new employees and incorporate an outsourced team for larger projects.
Mistakes with comp plans can be costly – due to excessive payouts and/or because they are not generating the expected results. Backtesting is one form of validation as you build a plan. Short-term incentive programs are another. Remember, without some risk, there is usually little reward, so accept that some risk must be taken to find the point where optimal behavior is fostered, and then adjust the plan accordingly.
It can be challenging and time-consuming to identify the right things to measure, the right number of things (measuring too many or too few will likely fall short of goals), and the incentives that motivate people to do what you want and need. Anything worth doing is worth doing well. Hopefully this post provided ideas on how to make that happen.
Profitability through Operational Efficiency
In my last post, I discussed the importance of proper pricing for profitability and success. As most people know, you increase profitability by increasing revenue and/or decreasing costs. However, cost reduction does not necessarily mean slashing headcount, wages, benefits, or other factors that often hurt morale and cascade into lower quality and customer satisfaction. There is often a better way.
The best businesses generally focus on repeatability and reliability, realizing that the more you do something, the better you get at doing it well. You develop a compelling selling story based on past successes, build a solid reference base, and identify the sweet spot from a pricing perspective. People keep buying what you are selling, and if your pricing is right, money is available at the end of the month to fund organic growth and operational efficiency efforts.
Finding ways to increase operational efficiency is the ideal way to reduce costs, but it takes time and effort. Sometimes this happens through increased experience and skill. But, often optimization occurs through standardization and automation. Develop a system that works well, apply it consistently, measure and analyze the results, and then make changes to improve the process. An added benefit is that this approach increases quality, making your offering even more attractive.
Metrics should be collected at a “work package” level or lower (e.g., task level), which means they are related tasks at the lowest level that produce a discrete deliverable. This project management concept works whether you are manufacturing something (although a Bill of Materials may be a better analogy in this segment), building something, or creating something. This allows you to accurately create and validate cost and time estimates. At this level of detail, it becomes easier to identify ways to simplify or automate the process.
When I ran my company, we used this approach to win more business with competitive fixed-price project bids that provided healthy profit margins while minimizing risk for our clients. Higher profit margins let us invest in our own growth and success by funding ongoing employee training and education, innovation efforts, and international expansion, as well as experimenting with new things (products, technology, methodology, etc.) that were fun and often taught us something valuable.
Those growth activities were only possible because we focused on doing everything as efficiently and effectively as possible, learning from everything we did – good and bad – and having a tangible way to measure and prove that we were constantly improving.
Think like a CEO, act like a COO, and measure like a CFO. Do this and make a real difference in your own business!
The Importance of Proper Pricing
Pricing is one of those things that can make or break a company. Doing it right takes an understanding of your business (cost structure and growth/profitability goals), the market, your competition, and more. Doing it wrong can mean the death of your business (fast or slow), the inability to attract and retain the best talent, and creating a situation where you will no longer have the opportunity to reach your full potential.
These problems apply to companies of all sizes – although large organizations are often better positioned to absorb the impact of bad pricing decisions or sustain an unprofitable business unit. Understanding all possible outcomes is an important aspect of pricing, especially when it comes to risk and risk tolerance.
When I started my consulting company in 1999, we planned to win business by pricing our services 10%-15% lower than the competition. It was a bad plan that didn’t work. Unfortunately, you see this approach all too often in businesses today.
We only began to grow after increasing our prices (about 10% more than the competition) and justifying it with our expertise and the value we provided. We were (correctly) perceived as a premium alternative, and that positioning helped us grow.
A few years ago, when I took over sales for the Americas, one of the first things I did was analyze everything that was within my control. Pricing and SKUs were an unexpected surprise. Nobody had looked at this since the company was launched three years earlier. We had multiple items with a single SKU, and many customers were buying one product (and often one or two subscriptions) and using many – which was both a pricing and compliance matter. We had a gateway product that was half the price of our DBMS and allowed products to run on competitor products. I added SKUs, doubled the price on gateways so companies would have a fair choice, and increased several products by 3%-5%. Those changes added 7% to our revenue over the next year.
Several years ago, I had a management consulting engagement with a small software company. The business owner told me they were “an overnight success 10 years in the making.” He was concerned they might not be able to capitalize on recent successes, so he sought an outside opinion.
I analyzed his business, product, customers, and competition. His largest competitor is the industry leader in this space, and products from both companies were evenly matched from a feature perspective. My client’s product even had a few key features that were better for management and compliance in Healthcare and Union environments that his larger and more popular competitor lacked. So, why weren’t they growing faster?
I found that competition was priced 400% higher for the base product. When I asked the owner, he told me their goal was to be priced 75%-80% less than the competition. He could not explain why, other than saying he believed his customers would be unwilling to pay any more than that. His lack of confidence in his product became evident to companies interested in his solution.
He often lost head-to-head competition against that competitor, but almost never on features. Areas of concern were generally the company’s size and profitability, and the risk each posed to prospects considering his product. And despite this being an issue over and over, he never came up with a proactive approach to diffuse this before it became an issue.
I shared the graph (below) with this person, explaining how proper pricing would increase profitability and annual revenue, and how both would help give customers and prospects confidence. Moreover, this would allow the company to grow, eliminate single points of failure in key areas (Engineering and Customer Support), add features, and even spend money on marketing. Success breeds success!
In another example, I worked with the Product Manager of a large software company responsible for producing quarterly product package distributions. This work was outsourced, and each build cost approximately $50K. I asked, “What is the break-even point for each distribution?” That person replied, “There really isn’t a good way to tell.”
By the end of the day, I provided a Cost-Volume-Profit (CVP) analysis spreadsheet that showed the break-even point. More importantly, it showed the contribution margin and demonstrated that these products provided very little operating leverage (i.e., they weren’t very profitable even if you sold many of them).
My recommendations included increasing prices (which could negatively impact sales), investing in fewer releases per year, or finding a more cost-effective way of releasing those products. Without this analysis, their “business as usual” approach would have likely continued for several years.
Companies are in business to make money – pure and simple. Everything you do as a business owner or leader needs to be focused on growth. Growth results from a combination of factors, such as the uniqueness of the products or services provided, quality, reputation, efficiency, and repeatability. Many of these are the same factors that also drive profitability. Proper pricing can help predictably drive profitability, and having excess profits to invest can significantly impact growth.
Some customers and prospects will do everything possible to whittle your profit margins down to nothing. They focus on their own short-term gain, not the long-term risk they create for their suppliers. Those same “frugal” companies expect to profit from their own business, so it is unreasonable to expect anything less from their suppliers.
My feeling is that “Not all business is good business,” so it is better to walk away from bad business in order to focus on the business that helps your company grow and succeed.
One of the best books on pricing I’ve ever found is “The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making” by Thomas T. Nagle and Reed K. Holden. I recommend this extremely comprehensive and practical book to anyone responsible for pricing or with P&L responsibility within an organization. It addresses the many complexities of pricing and is truly an invaluable reference.
In a future post, I will write about the metrics I use to understand efficiency and profitability. Metrics can be your best friend when optimizing pricing and maximizing profitability. This can help you create a systematic approach to business that increases efficiency, consistency, and quality.
At my company, we developed a system that tracked how long common tasks took and tracked efficiency factors for each consultant. This allowed us to create estimates based on the type of work and the people most likely to do the task, and to fix-bid the work. Our bids were competitive, and even when we were the highest-priced bid, we often won because we would be the only (or one of the few) companies to guarantee prices and results. Our level-of-effort estimates were +/- 4%, which helped us maintain a 40%+ minimum gross margin on every project. This analytical approach helped our business double in revenue without doubling in size.
There are many causes of poor pricing, including a lack of understanding of cost structure; Lack of understanding of the value provided by a product or service; Lack of understanding of the level of effort to create, maintain, deliver, and improve a product or service; and Lack of concern for profitability (e.g., salespeople who are paid on the size of the deal, and not on margins or profitability). Each of the experiences listed above has been a great lesson learned for me, and can help you as well.
With a little understanding and effort, you can make small adjustments to your pricing approach and models that can measurably improve your business’s bottom line.
Where Ideas, Experiences, and Lessons Learned Intersect 