Last month, we looked at an eye-opening study involving 1000 companies. It demonstrated that the four primary objectives most business owners have actually compete against each other. When the study’s authors arranged the four objectives into two pairings, they realized that the first objective, sales growth, competes against the second, profitability. At the same time the third objective, short-term earnings, bumps up against long-term earnings. It’s like a perpetual tug-of-war, progress on one side coming at the other side’s expense.
Fortunately, the authors, Dominic Dodd and Ken Favaro of the management consulting firm Marakon Associates, devised a process by which retailers can grow both objectives in each set of tensions. (The study “Managing the Right Tension,” appears in the Harvard Business Review, Dec. 2006.)
Step One: Figure out your batting average in both areas. In Step Two, you pick which pair of competing objectives (or “set of tensions”) has brought your batting average below 1.000. Step Three has two parts: First, avoid the temptation to pick just one objective in the set to focus on. That will only have you running in circles. Then, find a common bond between the competing objectives and strengthen that bond, so both can grow at once.
Step One will help you understand the extent you have fallen short of your potential. Start by writing down your total sales for the last five years. Put a check by the years in which Sales exceed the prior year. Next, write down your Net Profit Margin for each of the last five years. [You find NPM by dividing your Earnings (dollars) Before Taxes and Depreciation by your total Sales.] Check off any of the last four years when your Margin exceeded the prior year’s Margin. Then, check which of the last four years your company’s Sales and Net Profit Margin exceeded the prior year. In how many of the last four years did you grow both numbers? Example: if both grew during only one out of four years, your batting average would be .250 (1 divided by 4). That is your sales vs. profitability batting average.
Next, determine your economic profit. For each of the last five years, find the Interest rate you paid on Interest-bearing debt. (Total Interest Paid divided by the total of your Interest-Bearing Debt.) Add 1% to each year’s Interest rate; then, subtract that total rate from that year’s Net Profit Margin. The difference is your “economic profit.” It reveals earnings that exceeded your cost of capital (which is your Interest costs, plus 1% for administration). It’s the value your company added; the value you can show for all the work you invested. In which of the last four years did your economic profit exceed the prior year?
Next, compare each year’s economic profit to that in each of the following three years. For how many of the last four years did your economic profit continue to grow every year for the following three years? The answer is your short-term vs. long-term economic profit batting percentage.
If this calculating seems like too much work (and I realize you have customers, employees, and installers badgering you for answers), please keep the following in mind: I want you to find your economic profit because it foretells your future. A company may produce a Net Profit Margin (defined as income in excess of expenses), yet produce no economic value (defined as income in excess of the cost of capital). Such companies are churning money, but creating none. You want to know if you’re churning or earning! If your economic profit regularly exceeds your Net Profit Margin, congratulations, you are creating economic value in the company. If it does not grow each year, you are essentially liquidating your business.
Few retailers have a long-term view of economic value. But you need to remember that economic profit largely determines the value of the business when the owner sells it. When you sell, I’d like the buyer to pay you more than the garage-sale value of your physical assets.
When we consult with dealers, we urge them to weigh each new investment. Do you expect it to increase economic profit? Of course, you should also estimate the project’s expected impact on current sales, profit, and market-share. And don’t stop there. Ask yourself, “Which projects, which systems, which people will best increase the company’s long-term value?”
Now, compare your two batting averages. If both are 1000%, you win. If not, you have room to improve. To improve, move to Step Two. It shows you how to identify which set of competing objectives is responsible for your lower batting average.
It’s not a slam dunk to simply identify which set caused your shortfall, because the two sets work off each other. That is, poor performance in one set can cause poor performance in the other. Making things worse, owners often manage both sets in lock-step-boosting profitability and this year’s earnings, for example.
To help you identify which set is causing your problem, Dodd and Favaro found that each tension-set raises peculiar questions. The sales-profitability tension relates to the company’s business model. Regarding this tension-set, ask yourself and your staff: “What does our business do for customers? Is our Customer-Value Proposition (CVP) driving ever more traffic to our showroom? Is it persuading customers to pay us a premium for the privilege of buying from us?” On the expense side, ask yourself, “What does it cost us to support our CVP? Do we pay any costs that drive no sales and profits?” If you find negative answers, your business strategies are not working. This sales-profitability set of objectives has failed you.
The short-term vs. long-term tension-set relates to the company’s management model. First, it asks: “How do we manage our performance? How efficiently do we work? Where are we wasting time and materials?” Second, it asks: “How do we invest? Are we making money on our interest-bearing debt? Do we present the most appealing showroom in the area? Are we constantly assessing the market for our products and updating them? Are we investing sufficiently in our employees and their skill-sets?” Thus, this set raises questions about the company’s targets, systems, and processes.
After you answer these questions, you will discover whether your business model or your management model has caused your poor batting average.
When you’ve found which tension-set depressed your company’s performance, you’re ready to take Step Three. The first part of Step Three is to accept the findings of Dodd and Favaro: the best-performing companies learned not to push one objective to the exclusion of the other. Doing so only created more problems.
For example, if you were to choose to improve profitability, you would set prices to generate higher margins and would control costs. The result of controlling costs would be to blur the difference between costs that stimulate growth (“good costs”) and those that don’t (“bad costs”). When sales drop, the typical order is to cut costs across the board, including costs that stimulate growth. Then, again, in good times, the owner may tolerate cost increases because growing sales more than cover them. This allows costs not needed for growth to rise unchecked; they become locked in and drag down profits. Higher costs reduce the cash available for expansion, so the owner needs higher sales to justify new investment. Thus, focusing only on profits encourages the owner to watch costs more closely in slow times than in good times. I know I was guilty of that. When the money was rolling in, I didn’t watch costs that much.
On the other hand, if you chose to increase Sales (and pretty much ignore profits), you would pay attention to how you serve your customers. You’d accentuate the distinct nature of your Customer Value Proposition-different from those of competitors and desired by customers. You’d emphasize marketing and selling more effectively, to increase the appeal of your Proposition. You may add product lines. As a result, Sales would rise. However, your actions would work against profitability. They would increase complexity and likely reduce volume per line. They would then tempt you into discounting and encouraging higher-pressure sales methods.
Dodd and Favaro found, “These traps are the unintended side effects of sensible management practices.” Managers fall into the traps by working only one side of a set of competing objectives. How might you avoid the traps?
In next month’s article, we’ll look at the second part of Step Three, so you can see how to grow both competing objectives at once.