How To Avoid 3 Common Profit Drains

Editor’s note: Longtime Chief Executive columnist Jonathan Byrnes passed away on May 7 at age 75 after a long and valiant fight against cancer. The MIT professor, consultant and cofounder of Profit Isle was a brilliant mind, thoughtful businessperson—and kind man. We will miss him. This column is one of several that he submitted to us before his passing.

***

When I talk to managers about profit generation, I’m often asked about profit pitfalls—logic traps that lead to major profitability drains. Here are three big offenders:

• Marginal contribution. Why shouldn’t we take business that contributes to overhead, even if it doesn’t cover full cost?
  
  

• Full product line.  Why shouldn’t we carry products that lose money if they are part of a product line that makes money overall?
  
  

• Traffic drivers.  Why shouldn’t we carry money-losing “loss-leader” products if they attract customers who then buy very lucrative products?

Each of these questions seems to have a perfectly logical answer that leads to the conclusion that it is all right to carry money-losing business.

Let’s analyze each question carefully.

Marginal contribution

The question of contribution is one I hear in almost every talk and meeting. After all, the question goes, if our warehouses and trucks are not full, isn’t it better to take some business that helps cover the cost, than to leave them partly empty? This sounds sensible.

There are two big problems with this logic.

First, if a company takes business that doesn’t pay full freight, it also needs a strict “sunset” mechanism to divest that business (or reprice it) when full-freight business becomes available. In fact, companies almost never do this.

Instead they keep the marginal business because it provides so-called “volume.” When new business moves them beyond capacity, they simply build more capacity. The logic always is that the marginal business provides a contribution. Over time they wind up with a warehouse full of mixed business—some paying its way, most not. 

The second problem is much more insidious. If there is full-freight business available that has not been sold, the company is implicitly letting the sales reps “off the hook” by allowing them to fill their quota with marginal business. The false logic of taking business that covers variable cost but doesn’t pay for full cost removes the pressure on sales reps to do what they need to do: Continue to sell until they bring in lucrative business.

The net effect is a few Profit Peaks surrounded by a host of Profit Drains, and no one knows where the Profit Drains came from.

Full product line

The second profit pitfall also seems to have an unassailable logic. Since some customers want a supplier with a full product line, it seems obvious that a company has to have some losing products in order to make money on the overall product line.

This seems completely logical. But think carefully about it.

If this logic is true, than the company is essentially making an investment. It is investing in carrying money-losing products in order to generate incremental sales in other products that not only are profitable, but importantly, also cover the losses on the portion of the product line that is underwater.

This seems like a sound thought process—but it only makes sense if the company calculates the return on this investment, and shows that it is a good investment.

The counter argument is that it appears to be impossible to do this calculation. However, with an Enterprise Profit Management solution (EPM), a SaaS system that shows the net profitability of every product in every account every time it is purchased—and every account’s buying pattern—you can quickly make this determination. Remember, however, that if a minor, money-losing product is important to a number of your high-revenue, high-profit Profit Peak customers, it may well be a great investment.  

Here is a companion reason why product line logic is a profit pitfall. It assumes that you have to be a full-line supplier. In fact, a quick look around business over the past few decades shows that many very successful companies like Walmart do very well by positioning themselves selectively in key product categories, and competing on low costs and price. It goes without saying that the rock-bottom low costs and prices are generated by streamlining the supply chain and eliminating the extraneous, money-losing products.

Instead, all too many companies simply assume that they have to provide rapid service for a full product line at prices that are competitive with narrow-line competitors.

There is a way to do this, however. If you keep your steadily-consumed, fast-moving products in local distribution centers, and your other products in consolidated national or regional facilities—and you eliminate overly-frequent ordering—you can lower your cost to serve on the slower-moving products so you can carry a full line and make money on all or most of it.

Of course, your customers will have to agree to a slight delay—a longer service interval. But here’s the leverage point: You can keep enough local stock of slow-moving products for the customers who really are buying a full product line and for your Profit Peak customers—if you have an Enterprise Profit Management system that enables you to identify them.

For the customers that are cherry-picking you, they either can wait a little, or pay an expediting fee, or broaden their purchases to move into your most-favored customer category.

(Note that Apple, a high-end company, has maintained a compressed product line in order to simplify their customers’ choice, and reduce their manufacturing and supply chain cost.)

Traffic drivers

The third profit pitfall, traffic drivers, is very common. Here’s the apparent logic.

Your marketing strategy centers on attracting customers with a “loss leader”—a product or category that is priced low in order to develop further high-margin sales.

Today, many auto parts retailers view their fluids as a loss leader category. When customers come in to buy brake or window washing fluid, the logic goes, the customer will shop for higher-margin products, making the overall visit profitable.

Most companies have business that looks like this.

The logic underlying this product strategy is similar to the product line logic analyzed in the prior section. Essentially, the company is making an investment in pricing a traffic driver below full cost in order to generate high-margin sales elsewhere. But few companies actually track this in order to determine the real return on investment.

In fact, one auto parts retailer used Enterprise Profit Management to quickly calculate the payoff for its loss leaders based on the profitability of each customer basket. They found that overall, this strategy lost money, but for certain identifiable high-volume, do-it-yourself customers, it was a big winner. When they saw this, they changed their promotion strategy from offering loss leaders to everyone, to sending fluid-discount coupons only to their target customers.

As in the case of product line profitability, Enterprise Profit Management will quickly show which customers, over time, produce a threshold return on investment on the traffic drivers they consume. Armed with this knowledge, the company can build a smart set of incentives and linkages to move customers to the desired buyer behavior.

Where a customer is simply cherry-picking the traffic driver, the company can develop appropriate measures to minimize the losses.

Profit logic

What these three common profit pitfalls have in common is that each seems so logical.

After all, why shouldn’t you take business that helps pay for the overhead? Why shouldn’t you carry some losing products in order to make money on the whole line? Why shouldn’t you offer some loss leaders, or traffic drivers, to draw in customers who will buy high-margin products?

The truth is that each of these profit pitfalls does indeed have a reasonable-sounding logic. The really big issue, however, is determining where the apparent logic produces real results.

The problem is that in most companies, the policy that follows from the logic is applied indiscriminately, rather than targeted specifically at customers and situations where it makes sense—and not where it doesn’t fit. The power of Enterprise Profit Management is that it allows you to draw a line in the sand, and make this precise distinction—building your Profit Peaks while you reduce your Profit Drains.