The Profit Pitfall

Aug. 2, 2007
Why profit is the wrong metric for managing a manufacturing company.

The use of profit as the guiding metric is leading your company in the wrong direction -- and is a primary reason why your manufacturing company is not achieving its top potential.

Consider these truisms: Your fiduciary responsibility is to maximize profit; therefore, profit is the ultimate metric for managing your business. Increased profitability should be the focus of your Lean, Six-sigma and ERP efforts. The best way to choose among competing projects is to determine which one generates the most profit. Which of these statements is correct? None.

Manufacturers, which naturally gravitate to a cost and operations orientation, are particularly susceptible to three inherent profit pitfalls:

  1. A Lagging Indicator. Profit is the byproduct of actions taken in the past -- sometimes the distant past. By the time declining profit catches your eye the damaging deed is done and the repair job may be extensive. For example, automotive supplier Johnson Controls ate millions of dollars in unnecessary freight charges for years before they were identified as a profit drain.
  2. A Poor Guide. Profit is merely a result. It gives no indication of which activities are lining the coffers and which are draining valuable resources. As a result, companies resort to complex scorecards with dozens of "key performance indicators" and competing top priority projects. The Highjump division of 3M issued a sales guide outlining the different metrics needed to convince various decision makers. Putting aside 3M's observation that different offices in the c-suite use entirely different criteria to make funding decisions, it is interesting to note that not a single one of the influencing metrics was profit.
  3. Disconnected From Non-Financial Success Factors. Though profit is measured in dollars, many contributors to success are not: organization design, sales approach, cycle times, batch sizes and myriad other critical elements are poorly captured by traditional accounting approaches. This was the case at Krispy Kreme Donuts, whose precipitous sales decline in 2003-2004 was preceded for at least six months by measurable levels of customer dissatisfaction. Customer satisfaction and profit had not been linked tightly enough to trigger immediate action.

All three of these profit pitfalls preyed on a Midwest packaging company we encountered. Faced with tumbling profits, they instituted an aggressive cost-cutting effort: every department was required to reduce expenditures 15%, they "leaned out" their manufacturing and used six-sigma to drive costs out of the system. Management meetings were a cacophony of frustrated voices arguing over which cost-saving projects were most important, while "non-essential" projects were shunted aside to keep focus on the quest to preserve margins. In fact, without realizing it, their relentless pursuit of profit almost drove them out of business.

Just before doomsday, company leadership reached an epiphany: profit is a result, not a management metric. They installed a new approach which arrested their downward spiral and guided them to triple-digit growth over the following two years. The measure they embraced to guide all their decisions focused on the ultimate arbiter of corporate success: customers' buying decisions. They correctly concluded that developing sustainable ways to capture more purchases would inexorably result in profit growth; conversely, attempts to boost profit often failed to put customers in their camp.

The actual metric they used was called "Customer-Market Efficiency," a term I coined for a measure which directly ties every critical corporate activity to customers' buying decisions. Customer-Market Efficiency is a single number, like profit, but it is the output of a model which includes customers' decision processes and corporate activities then connects the two. This metric is a boon to manufacturing companies striving to maximize their return on finite human and financial resources. It is a leading indicator, giving immediate feedback if a planned initiative won't create sustainable sales gains; it gives very specific guidance on what projects will generate the greatest long term growth; and, it incorporates all success drivers -- both financial and non-financial.

At the packaging company, the new metric revealed issues precipitating the ongoing profit slide. For instance, when we mapped every activity in the plant to customer's buying decisions, significant mistakes in the manufacturing flow instantly appeared. This is typical of the money-making "surprises" revealed when a company substitutes customer-driven metrics for the traditional cost-accounting controls.

A better way to manage your company is only four steps away:

1. Improve your understanding of customer needs. Since success rests on customers' buying decisions, the starting point is to model the complex array of interacting factors which determine their choices. Chances are neither you nor your customers truly understand this.

Recent research shows people are unaware of many influences on their decisions and simply fabricate a rational explanation when asked to disclose their selection process. Additionally, most companies rely on market research approaches developed years (if not decades) ago, which don't leverage the extraordinary computational power available today to model customer decision making.

2. Link the customer decision model to the activities across your company. Your investment in customer understanding delivers the greatest returns when you can directly model the effect of any change, say, the number of crews maintaining a certain machine, on purchase decisions. We call this step "holistic business system mapping" because it creates a virtual map tying the key elements throughout the business back to the customer.

One output of this step should be a single metric which, like profit, is easy to track and communicate throughout the organization. Every department and individual should then have goals tied to improving your performance on this metric. Unlike profit, however, individuals and departments can easily understand their role in the overall picture and connect their everyday activities to the company's success.

3. Use the combination of in-depth customer knowledge and links to the business process to identify inefficiencies and constraints which are preventing you from pleasing your current customers at the lowest cost to you.

Whereas most lean and six-sigma thinking focuses myopically on reducing costs, this approach directs your process improvement efforts only to areas where cost reduction and improved controls will not negatively affect purchase decisions. (You don't want to end up cost controlling your way to appalling customer perception like Northwest Airlines, Dell or Home Depot.)

4. Explore opportunities to increase sales through incremental initiatives -- before you make significant investments. One bonus of having an excellent model of customer decision making linked to corporate activities is the ability to run "what-if" scenarios on investments in equipment, human resources, products and processes.

Prioritization of competing initiatives becomes easy because efforts as varied as department reorganizations, new capital equipment, and training can be compared apples to apples based on their impact on sales. This has proven to be an exceptional vehicle for aligning diverse senior management teams behind one or two business-building projects.

The mental leap from believing profit is the guide to realizing it is merely the result of favorable customer buying decisions is where many executives falter; however, a bright path of ascending profits is in store for those who use a customer-based metric to direct management decisions.

Sign up for a free teleseminar on using Customer-Market Efficiency at David Fields is managing director of Ascendant Consulting, LLC, a consulting firm dedicated to accelerating companies' top-line growth Is profit-based management leading you astray? David A. Fields can be reached at 203-493-0166 or [email protected].

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