Create A Profit Early Warning System

Understanding your earnings on a granular level is the missing link in financial oversight at the board level. Here’s how your CFO can make that happen.

No one wants to be surprised by an unexpected miss in profit results. However, most companies today have a critical gap in their CFO and board of directors’ financial management: They know their net profits, but they are missing a precise, quantitative measure of how robust or fragile their earnings are. Enterprise Profit Management (EPM) provides this critical missing metric.

Enterprise Profit Management is the essential complement to traditional financial management. Traditional financial metrics focus on broad aggregate measures like revenue, gross margin and operating cost, which were developed centuries before the current digital era. EPM utilizes today’s powerful analytical technology to calculate the all-in profitability of every transaction (invoice line) of a complex company.

Because each transaction has a unique set of identifiers (customer, product, sales rep, supplier, date and so on), EPM systems can use their flexible, proprietary data structures to determine in a few weeks the profitability of literally every nook and cranny of a company—down to every product bought by every customer every time—and then update this view every period to reflect the ongoing changes in your business.

With this granular profit information covering every aspect of their company, financial managers can determine both (1) where they are making money, and (2) how stable, reliable and resilient their earnings are.

In our experience analyzing and improving over $100 billion in client revenues across a range of industries, a characteristic profit pattern emerges:

• Profit Peak customers—large, high-profit customers that comprise about 10-15% of your customers, and produce about 150-200% of your reported net profits

• Profit Drain customers—large, money-losing customers that comprise about 10-15% of your customers, and erode about 33-50% of this amount

• Profit Desert customers—the remaining small customers that comprise about 70-80% of your customers and produce minimal profits while consuming half or more of your company’s resources

The same profit segmentation holds for products, suppliers, sales reps, stores and other critical business dimensions. This is the basis for your profit early warning system.

For example, consider two companies in the same business, both very profitable. Company A generates 200% of its reported profits from its top 50 Profit Peak customers, most of whom are relatively new accounts and concentrate their purchases on a few products. Company B generates 200% of its profits from the full range of its 1,500 Profit Peak customers, most of whom are long-term, stable accounts that buy a full range of products with strong intercompany ties through vendor-managed inventory (VMI).

Although both companies have the same earnings, Company B’s earnings are much more robust than Company A’s. If the earnings of a few of Company A’s top 50 Profit Peak customers start to erode, it is a serious danger sign, while if a few of Company B’s top 1500 Profit Peak customers diminish their purchases, the company’s aggregate earnings will not be endangered (unless this is the starting signal of a larger trend).

Conversely, consider two other successful companies in the same business. Company C has 50 Profit Drain customers that together erode 40% of the earnings generated by their Profit Peak customers, while Company D has 300 Profit Drain customers that erode 40% of the profits generated by their Profit Peak customers.

Company C’s tight concentration of big losses in a relatively small number of customers makes it feasible to form a multicapability “tiger team” that can use its EPM P&L information on each customer to improve its profitability. Company D, on the other hand, has a widespread problem with many large money-losing customers. Company D’s managers will have much more difficulty in stemming the profit drains because they are spread across so many more customers.

The action-question of paramount concern to CFOs and boards is how to create a systematic profit early warning system that they can monitor—as a complement to their monitoring of the company’s traditional broad, aggregate metrics.

Profit CT Scan

Enterprise Profit Management’s transaction-level metrics provide the information that enables you to monitor the components of your company’s profit-generating system. It acts as a CT scan that systematically peers beneath your company’s traditional surface metrics to identify and analyze any latent or emerging problems before they grow.

Several factors are broadly indicative of profit health. However, each company needs to tailor and weight the EPM factors to fit its specific situation (e.g., a distributor with continuing customers vs a project-oriented company).

Here are some factors that we have found to be most indicative.

Customer Factors

• Customer profit segmentation—the proportion of profits or losses generated by the Profit Peak, Profit Drain and Profit Desert customers, both current and erosion/growth over time

• Customer profit concentration—the proportion of profits generated by the top quartile of Profit Peak customers, and the proportion of losses generated by the bottom quartile of Profit Drain customers

• Customer lifetime value—the length of time a customer has been an account of the company; the length of time a customer has been in its current profit segment

• Customer product mix—the concentration of a customer’s profits across its purchased product mix

• Customer integration—the penetration of value-added services like vendor-managed inventory, configured products or joint category management that increase switching costs

Product Factors

• Product profit segmentation—the proportion of profits or losses generated by the Profit Peak, Profit Drain and Profit Desert products, both current and erosion/growth over time

• Product profit concentration—the proportion of profits generated by the top quartile of Profit Peak products, and the proportion of losses generated by the bottom quartile of Profit Drain products

• Product customer mix—the concentration of a product’s profits across its customer mix

• Breadth of core product purchases—in some companies, the breadth of sales of “core products” that are hard to switch and that “pull through” sales of related ancillary products

Profit Early Warning Matrix

A Profit Early Warning Matrix is the most effective way to analyze and summarize this profit robustness information. It can display both a company’s current profit situation and exploratory scenarios that probe its profit vulnerabilities.

Figure 1 below shows a Profit Early Warning Matrix for a typical successful company. The vertical axis shows the company’s customer profit segments, while the horizontal axis shows the company’s product profit segments. The nine nodes within the matrix show the characteristics of the intersections of the respective segments.

For example, the matrix shows that Profit Peak customers purchasing Profit Peak products generated 32% of the company’s revenues, but fully 167% of its profits. On the other hand, the Profit Drain customers buying Profit Drain products generated only 9% of the company’s revenues, but eroded a whopping 49% of its profits.

Inspecting the other nodes reveals a number of important surprises. For example, when Profit Drain customers purchase Profit Peak products, they generate 11% of the company’s revenues, and contribute fully 18% of its profits. This strongly suggests that these customers should not be terminated, but instead that their product mix needs systematic curating. Conversely, when Profit Peak customers purchase Profit Drain products, they account for 27% of the company’s revenues, but erode fully 26% of the profits. Again, this indicates a strong need for careful management of the product mix of even the most profitable customers.

The horizontal row under the matrix summarizes the product segments across all customers, while the vertical column to the right of the matrix summarizes the customer segments across all products.

The Profit Early Warning Matrix is a critical profit management tool: It is the starting point for profit early warning risk assessment. The Enterprise Profit Management SaaS system enables a CFO and/or board of directors to easily model the customer and product profit robustness factors listed above (and others that may be unique to a specific company) and to stress-test the company’s profitability.

Profit Stress Test

The Profit Early Warning Matrix allows you to separately analyze each node (e.g., Profit Peak products purchased by Profit Peak customers) with all of the detail you need to do a sensitivity analysis of each customer and product factor.

For example, you might look at the impact of losing 10 Profit Peak customers or products. You also can model the impact of changes in pricing, product mix or cost to serve (e.g., order frequency). This will show your company’s most important vulnerabilities or, conversely, profit levers. It is easy to estimate probability distributions of a range of likely outcomes for each factor, and to view the impact on a specific matrix node, as well as your overall company.

This analysis enables the CFO and board members to pose what-if questions that explore all aspects of a company’s profit-generating system, to identify potential weaknesses and to take preventive or remedial actions that ensure the company’s continued profitable growth.

Manage Your Profit Growth

The Profit Early Warning System is invaluable because it provides the detailed transparent understanding of a company’s profit stability, reliability and resilience that CFOs and boards so urgently need.

It also provides a clear, well-grounded basis for developing a set of extremely focused, effective initiatives for reducing profit risk and accelerating profit growth. As these critical profit initiatives are executed, the updated Profit Early Warning Matrix can provide integrated tracking of each initiative and monitor the impact on the overall company.

The Profit Early Warning System fills the missing link in CFO-board financial management, shaping, energizing and directing the company to sustained, accelerated profitable growth both in the near term and in the years to come.

Jonathan Byrnes is a Senior Lecturer at MIT, and Founding Chairman of Profit Isle. John Wass is CEO of Profit Isle, a profit acceleration SaaS company with proprietary analytics that have produced sustained year-on-year profit increases on tens of billions of dollars of client revenues. Jonathan and John are co-authors of the forthcoming McGraw Hill book, ”Choose your Customers: How to Compete Against the Digital Giants and Thrive”.