How To Manage Your Most Important Risk

Shift your metrics if you want to address the dangers to profitability most effectively.

Your most important risk is losing your profitability. Enterprise Profit Management (EPM) metrics enable you to directly and accurately measure and manage this risk in three steps:

• Identify your high-profit customers—the 10-15% of your customers that produce 150-200% of your reported profits;

• Identify and gauge the most important risks to these customers; and

• Devise and implement measures specifically targeted at preventing profit erosion and enhancing profit growth in these customers.

Current risk management analytical frameworks and management processes do not accomplish this critical goal. Enterprise Profit Management does.

Identify Your High-Profit Customers

The metrics that most companies use to manage their business processes, specifically including managing risk, are not adequate for today’s business needs. These metrics are broad, aggregate measures like revenues, gross margins and costs. They show whether a company is making money, but not where it is making money. Effective risk management requires metrics that show both.

Over the past 20 years, mass markets have been fragmenting as the digital giants vacuum up the small, arm’s length business, and incumbent companies are forced to develop defensible higher-service strategies. The mass markets of the prior century, which created an extended era of prosperity, were largely homogeneous with relatively uniform prices and cost-to-serve. Basing business processes on revenue maximization and cost minimization made sense.

In today’s fragmenting markets, managers have to tailor packages of products and related services for specific target market segments, or even individual customers. In this context, both prices and cost-to-serve vary widely. EPM creates profit metrics that specifically respond to this change.

Enterprise Profit Metrics are based on transaction-level profit analytics which match each increment of revenue with the specific, all-in cost to provide it. In essence, EPM creates a full, all-in P&L on every invoice line. Because each invoice line has a specific set of attributes (e.g. customer, product, vendor, store, sales rep, day), EPM’s data structures can combine and recombine these transactions to identify the profitability of every nook and cranny of a complex company.

Because the costs can be directly derived from a company’s general ledger, they are very accurate and timely. In about three weeks, SaaS-based EPM can produce a company’s comprehensive profit landscape down to business segments, individual customers and products, and even individual transactions, with monthly updates reflecting the latest financials.

In our experience, virtually all companies have this typical profit pattern:

• Profit Peaks are the large high-profit customers that comprise about 10-15% of a company’s customers and produce 150-200% of the reported profits;

• Profit Drains are the large money-losing customers that erode about 33-50% of this amount; and

• Profit Deserts are the remaining numerous, small, minimal profit/loss customers that produce few, if any, profits, but often consume half or more of a company’s resources.

EPM enables you to identify your Profit Peak customers (and products, stores, sales reps and so on). The number one priority of an effective risk management process is to discern and counteract the risks that are specific to these customers.

Identify and Gauge the Most Important Risks to Your Profit Peak Customers

Once you have identified your Profit Peak customers, the next step is to identify and gauge the most important risks to them. These risks are both external (e.g., new competitors, hurricanes, strikes) and internal (e.g., “hunter” sales reps bringing in Profit Drain customers because they can’t distinguish the Profit Peak customers from the Profit Drains).

As an example of an external risk, additive manufacturing (in which products are built up by heat-hardening a powdered substance, rather than sculpting metal blocks with metalworking tools) is a new technology that now comprises about 6% of the market, but much more in industries like aircraft parts, toys and medical devices. If 10% of a company’s customers are Profit Peaks, but 30% of the Profit Peaks are in danger of switching to additive manufacturing vendors (or self-producing products), it could quickly result in an enormous profit drain.

Similarly, a company might be facing a potential supply chain disruption affecting an important product. EPM enables the company’s managers to identify which of its Profit Peak customers are purchasing the endangered product, and take steps to give these customers priority.

Internal risks are important as well. One of the most important risks is hidden and unmanaged in all too many companies: the risk of sales reps targeting Profit Drain customers because they have no metrics to distinguish Profit Drains from Profit Peaks. Most companies seek and nurture all large customers, rather than those who are Profit Peaks.

For example, one large company’s Profit Peak customers produced about $750 million in revenues and $150 million in profits. The company’s Profit Drain customers produced about $875 million in revenues, but lost $75 million in profits. The company’s biggest risk was having their sales reps acquire and develop Profit Drain customers—because they were paid to increase revenues, and they had no information on customer all-in net profitability which would enable them to target Profit Peak prospects.

Devise Measures to Counteract Risks to Your Profit Peak Customers

It is remarkable that these enormous profit risks, which involve such a small proportion of a company’s customers, are hidden by the broad metrics that dominate most companies’ decision processes.

In the example of additive manufacturing, only 3-4% of the company’s customers would be affected. Traditional risk management processes probably would focus instead on a potential incursion by a digital giant like Amazon that threatened perhaps 10-15% of the company’s Profit Desert customers—even though the profit impact would be minimal and the resources would be much better spent counteracting the additive manufacturing threat (perhaps by developing an internal additive manufacturing capability or by supplying the ancillary materials).

The example of the supply chain disruption invites countermeasures that reflect the company’s profit segmentation. In this situation, a typical service differentiation policy might provide 100% of Profit Peak customers’ needs, 75% of Profit Drain customers’ needs and only 60% of its Profit Desert customers’ needs.

Importantly, most Profit Drain customers are not unprofitable because they have above-market prices, but rather because they have excessive unmanaged operating costs (e.g. overly frequent ordering). Many of these customers may be persuaded to cooperate in reducing your high cost-to-serve (which often is costly for the customer as well) in return for an allocation of 100% of the customer’s needs.

The third example, hunter sales reps bringing in likely Profit Drain customers, can be counteracted by providing the sales reps with EPM actual all-in profit profiles of both their current customers and prospective targets, and adjusting the sales compensation system to reflect account profitability rather than revenue or gross margin.

Because a company has a number of Profit Peak and Profit Desert customers, it can develop a reasonably accurate profile of the customers in each profit segment (supplementing this with surveys, if needed). These profiles would guide the sales reps in targeting not just large customers, but large, high-profit, loyal, price-insensitive customers.

In all these cases, the needed countermeasures are very effective, relatively inexpensive and quick to implement.

Why Traditional Risk Management Processes are Inadequate

Traditional risk management processes are fundamentally flawed. They typically start by identifying likely risk factors like strikes, storms, computer fraud and competitive incursion. Then they evaluate whether each risk factor is important (revenue eroding or cost increasing), and likely. Based on this, they prioritize the risk factors and develop countermeasures.

This process incorrectly assumes that all revenues and all costs are equally valuable. If 10% of your customers are providing 150% of your revenues, and 20% of your customers are eroding 50% of this amount, the real risk is decreasing your Profit Peaks and/or increasing your Profit Drains—not decreasing aggregate revenues or increasing aggregate costs.

EPM enables you to target your resources so you have high growth in both revenues and profits, even if you have increasing costs (because high-profit customers warrant better service, which is a terrific investment).

The second big issue with traditional risk management processes is that they are vague and analog. Once a risk management team identifies a set of risks, it typically roughly estimates each factor’s importance and likelihood using vague analog measures like high, medium or low, or imminent vs long-term.

Enterprise Profit Management enables you to identify the specific sets of customers that would be affected by a risk factor, and measure the profit impact with digital precision. This enables you to project much more accurate expected value estimates (using probability distributions), focus your resources on avoiding or counteracting the real risks to your profitability, and develop a high-profit, defensible strategy for your company.

This is the key to winning in both 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”.