Top Ten Reasons for NOT Managing Profitability

Today, our persistently weak economy is driving small businesses into two camps: the few that are growing fast, and the many that are struggling. For most, staying in place is sliding toward failure. Effective profitability management makes all the difference.

A few days ago, I discussed my new book, Islands of Profit in a Sea of Red Ink, with an officer of an industry association with many small business members. Her questions reflected discussions I’ve had with small business owners and managers over the years. Here are the top ten concerns.

#1 –  I’m already doing it.

There is a huge difference between managing budgets and managing profitability. Virtually every company I’ve seen –  large and small, in over a dozen industries –  is 30-40% unprofitable by any measure, and 20-30% of the business provides all the reported profits and subsidizes the losses. Even the industry leaders. Why?

Because they make three big mistakes: (1) assuming that more revenues means more profits; (2) failing to identify and focus on their profitable core of business; and (3) failing to develop appropriate information and processes to manage profitability.

#2 – It’s a big company thing.

Wrong. It’s really important for a big company, but it is life or death for a small business. In this economy, the companies that focus on their profitable core of business are making big gains in market share and profits. I’m familiar with one small company that worked with an important customer on a new business process that really improved the customer’s productivity – its sales rose from $10 thousand to over $1 million in a year.

#3 – I don’t know how.

Four building blocks: (1) the right information – granular (specific products in specific customers) not aggregated; (2) the right priorities – first, secure and grow the profitable business, then improve the marginal business, then reprice the money-losers; (3) the right processes – mostly coordinating sales, marketing and operations to get things right; and (4) the right compensation, especially for sales – matching compensation to real profitability not just revenues.

#4 – I’m too busy selling.

This is a common concern because many small business owners are also chief customer officers. The real problem is that the sales force is not focusing on securing and growing the profitable core. So their efforts are dissipated over a lot of unprofitable business – much of which can be turned around with a few focused measures.

#5 – I’m too busy cutting costs.

This is a big problem. If all revenues are viewed as good, all costs are viewed as bad. This leads to the big mistake of across-the-board cuts, when this is exactly the time when the company should invest in growing its profitable core of business, and generate cash by turning around its marginal business.

The most successful companies today are making big gains in market share by working with their best customers to create joint supply chain and marketing efficiencies. This increases the customers’ profitability – driving huge sales increases, while lowering the supplier’s own costs.

#6 – My CFO is really stretched.

Islands explains “profit mapping” –  how to develop much more granular information than that produced by accounting systems. You have to look at the profitability of specific products in specific customers. The book gives examples of how even profitable customers have 30-40% unprofitable business, which can be reversed with surprisingly simple measures.

How long does this take? A couple of capable managers can develop a profit map in 4-6 weeks using standard desktop tools. Even a busy CFO can easily oversee the process.

#7 – My customers are hammering me on price.

When you make your best customers more profitable, you are no longer a commodity provider. Price pressure simply disappears.

Remember that your first priority is to secure and grow your profitable business, before your competitors attack it. This is the biggest danger – and opportunity – you face.

#8 – We can’t afford expensive new software.

No need – see #7 above.

#9 – We’re all making budget.

Budgets are developed and performance is judged relative to history not potential. If a company is 30-40% unprofitable, and its budget aims for a 10% improvement, the company will still have a huge amount of embedded unprofitability.

#10 – I don’t know where to start.

Great question. Many managers simply assume that leading a profitability turnaround requires a big, one-time, disruptive reorganization. This is a huge mistake.

In fact, the most effective turnarounds are more like getting healthy by eating good food and getting regular exercise. The process is not particularly difficult or painful, but it is a very different way of managing. I wrote Islands of Profit in a Sea of Red Ink to guide you step-by-step through this process.

What’s the first step? Develop a profit map – you’ll be amazed at what you’ll see.

Stumbling on Customer Service

Some of the most useful books for business aren’t about business at all.

Recently, I read a terrific book that is extremely readable and very relevant to business, Stumbling on Happiness, by Daniel Gilbert. Gilbert is a professor of psychology at Harvard. This book is a very well-written and well-researched discussion of how people actually anticipate, perceive, and recall their experiences.

Bottom line: many of the assumptions that we make about how customers will react to customer service and many other customer-facing activities are misleading and incorrect. Consequently, we have a big opportunity to shape our customers’ experiences in ways we probably haven’t imagined. Similarly, we make systematic misjudgments in our decision-making, both in daily activities and in major initiatives.

I strongly recommend reading this book. I offer below a number of interesting points – all well documented – that emerge from the book. I’ll make a few suggestions about how these points tie into business activities, but leave it up to your imagination to draw the inferences for your business.

Optimism

We tend to overestimate the likelihood of good events occurring; thus people are unrealistically optimistic. Even if a bad event occurs (e.g. an earthquake), within a few weeks people are unrealistically optimistic again. (Think about the implications for deciding whether to end an initiative or program with only mediocre performance.)

People are even more unrealistically optimistic if a very bad event occurs. For example, cancer patients are more optimistic than their healthy counterparts.

Control

If a bad event is predictable and we anticipate it, we develop ways to rationalize and adjust to the impact. This gives us a feeling of control. Gilbert cites experiments in which subjects who receive strong shocks in a regular pattern deal with it better than subjects who receive mild shocks at unpredictable intervals. (Think about your policy for letting customers know in advance about service problems.)

People find it gratifying to exercise control, not for the result but for the exercise itself. When people lose the ability to control things, they feel unhappy, helpless, and despondent. Losing control has much worse effects (on health and wellbeing) than never having had control. The feeling of control is one of the wellsprings of mental health. (I recall reading about classic industrial engineering experiments in which assembly line workers who were allowed to work to the bottom of a bucket of bolts were much happier and more productive than those who had the bucket endlessly refilled.)

We really value the freedom to choose. People will pay a premium today for the opportunity to change their minds later, even if the economic consequence is overwhelmingly unfavorable.

Shaping perceptions

If a person describes his or her reaction to an event just after the event, the person will recall the description rather than the event, even if the description is not accurate. Most events have both positive and negative aspects. This means that you can shape someone’s recollection by asking questions that highlight the aspects you want the person to remember.

This works prospectively as well. If we suggest that someone focus on one aspect of an event, he or she will tend to disregard the other aspects. There are several commonly used film clips that illustrate this. For example, in one clip, viewers are asked to count the number of times a group of people pass a ball to one another, and the viewers fail to notice a gorilla walking through the group. (Again, this suggests ways to shape customers’ perceptions of actual experience.)

Information acquired after an event actually alters a person’s memory of the event. (For example, if you give a report card on your overall service, it will obscure a customer’s recollection of individual problems.)

Anticipation

When we imagine an upcoming event or an object (e.g. a plate of spaghetti), we visualize it as being much richer and more ideal than the full range of possibilities. This inevitably leads to disappointment.

People have a general inability to think about the absence of events. For example, a person will readily remember tripping, but not be aware of all the times he or she didn’t trip. (This is why rare customer service problems unrealistically dominate customers’ perceptions.)

When we are selecting something, we focus on the most positive attributes. When we are rejecting something, we focus on the most negative. This leads to a common situation in which a person will both select and reject the same thing at the same time by focusing alternatively on positive and negative attributes, becoming paralyzed with indecision. Here’s another example of our tendency to overestimate the extremes: we overestimate the happiness of people in California, and underestimate the happiness of people with chronic illness or disabilities – both have a “normal” degree of happiness.

Predicting the future

When we think about events in the distant future, we focus on why they will happen; when we think about events in the near future, we focus on how they will happen. Think about promising to babysit for a weekend several months in the future versus thinking about the details of what you will do when the weekend starts tomorrow. (This is very relevant to evaluating mergers and other big initiatives: from a distance we leave out consideration of the implementation details, and later wonder why we committed to do it. The upshot: get immersed in the details early so your evaluation is realistic.)

People tend to assume that the future will look largely like today. Underestimating the future is a time-honored tradition. Arthur Clark observed, “When a distinguished but elderly scientist states that something is possible, he is almost certainly right. When he states that something is impossible, he is very probably wrong.” People almost always err by predicting that the future will be too much like the past.

When we have “holes” in our conceptualization of the past and the future, we plug in today. This means that our predictions are prejudiced by assumptions that things will not change. It also means that our view of past relationships and events is changed by what we feel today. This is especially powerful in predicting how we will feel, or in remembering emotions. People have great difficulty imagining that they will later (or previously) feel differently than today. This is not a “logical” issue, but a psychological one: we can visualize objects changing, but can’t “prefeel” emotions differently from our current experience.

We remember feeling what we believe we must have felt, rather than what we actually felt. Memory is less like a photograph than a collection of impressionistic paintings.

Preference for variety

People imagine that they would prefer variety more than they do. The reality is that they only prefer variety if habituation sets in. Otherwise, in episodes separated by time, they strongly prefer favorites.

Relative preferences

People are much more sensitive to relative amounts than to absolute amounts. In experiments, subjects preferred to receive a pay progression of $30 followed by $40 followed by $50, rather than $60 followed by $50 followed by $40, even though the latter amounted to more. Similarly, we prefer the sequence of a bad deal changed to a decent deal, to the sequence of a great deal changed to a good deal – even though the latter is “objectively” better.

We are more willing to contribute a small amount if we are first asked to contribute a much larger amount. The same applies to paying for a product or service. This is why stores often place an overpriced item next to a very overpriced item.

It is very hard for people to choose among similar items. In experiments, physicians faced with the choice of prescribing two similar medications prescribed neither much more often than those physicians who only had one medication available. (Think about the implications for product assortments.)

People prefer to avoid a loss, more than to have the possibility of a gain. Many transactions fail because the seller overestimates his or her prospective unhappiness, while the buyer underestimates his or her prospective happiness. The seller implicitly wants compensation for a possible powerful loss, while the buyer expects a less powerful gain. (Think about the implications for negotiating an acquisition.)

Perceptions of difficulties

People are very resilient in the face of trauma. Most bereaved people experience a relatively short period and low level of distress, relative to their expectations. The same is true of people who suffer a disability.

In fact, most people consider their lives enhanced by the experience of trauma. This is the result of what Gilbert calls our “psychological immune system,” which causes us to adjust quickly and rationalize the impact of a truly traumatic event. In a strange example, able-bodied people are willing to pay much more to avoid being disabled than disabled people are willing to pay to be able-bodied again. When things really go wrong, our minds actively shape our perceptions to make the best of things.

Paradoxically, it is more difficult to achieve a positive view of a somewhat bad experience than a really bad experience – because in truly difficult circumstances our minds find ways to justify and rationalize the new situation, while they do not do this with normal setbacks. Suffering triggers defense mechanisms that eradicate it, but we can’t predict that this will happen.

We are more likely to develop a positive view of something if we are stuck with it. Hence, patients feel more distress if a medical test is inconclusive than if it is positive.

Open-mindedness

We seek data that confirms what we already believe. In studies, researchers have shown that the wide availability of information on the Internet has led to increased polarization, as people focus on the information that reinforces their preconceptions, rather than weighing information that supports alternative positions.

Similarly, our minds select from our memories the “facts” that fit our preconceptions, and this strongly shapes our perceptions and even our recollections.

People ask questions that elicit the answers they want to hear.

Interestingly, when people have a problem, they especially seek information about others doing more poorly than themselves. For example, in a study, 96% of cancer patients said that they were in better shape than the average cancer patient.

Expectations and regret

When we feel dread in anticipation of something, we assume that this is how we will experience and recall the event. Our most consequential choices (e.g. marriage, profession) are most shaped by how we imagine our future regrets. We are especially prone to exaggerate our view of future regret when the choice is unusual rather than more conventional. (“Showcase” projects can ameliorate this because they are a low-risk way to generate new experiences.)

In an interesting study, 90% of respondents expected to feel more regret if they foolishly switched stocks, than if they foolishly failed to switch stocks. Most people think they will regret foolish actions more than foolish inactions. But in reality, after the fact 90% of people really regret not having done things more than they regret things they have done. It is easier to visualize or imagine inactions than new actions with uncertain consequences.

People consistently choose certainty over uncertainty, and clarity over mystery.

The bottom line: it is very hard to predict accurately our reactions to future events because we can’t imagine them, or what we will think and feel if they happen.

Changing the perception of experiences

Explanations change people’s extreme perception of experiences. For example, simply talking, and especially writing about a trauma will generate surprising improvements in well being and physical health. This is particularly true when the writing contains an explanation of the trauma. Similarly, writing ameliorates the impact of an extremely good event.

What is memorable

We remember unusual and infrequent events (e.g. where we were on 9/11) and assume that they are more common than they really are. (Perceptions of customer service are formed by the worst experiences, not the average.) This is why we repeat mistakes so often.

We remember the end of a sequence much more than the beginning, middle, or average. People’s perceptions are overwhelmingly shaped by the most recent events. In studies, people were more concerned by how they would feel at the end of their lives, than about the total amount of happiness they experienced in their lives.

Making predictions

The best way to make predictions about future happiness is to find someone who is now having the experience and ask how he or she feels. (This is especially important in a job search. It also reinforces the importance of “showcase” projects.)

Summary

There are three main problems with the way our imagination works: (1) our minds fill in and leave out information in predictable, but unexpected ways, and we don’t even realize it; (2) we project the present into the future, and again don’t realize it; and (3) we fail to see that things will look different once they happen.

Here’s a final thought: the average person doesn’t see himself or herself as average. We attribute other people’s choices to features of the chooser (e.g. Jim prefers red ones), while we attribute our choices to characteristics of the choice (e.g. it had a richer color).

Customer service and decision-making

When we conceptualize and measure customer service, we most often simply assume that people are “rational.” Thus, it seems obvious that if we produce 96% service, it is better than 95% service.

But the insights that Gilbert offers instruct us that there is a lot more to it than that. A simple example: If the 95% is accompanied by a warning and explanation of impending problems, and the customer can choose a substitute or alternative, the customer will be happier than if he or she received a higher nominal service level with no “heads-up” or ability to exercise control. (Remember: the only thing worse than bad news is no news.)

Similarly, a company with a 98% service level with a few memorable disasters will be perceived more negatively than a competitor with a 94% service level accompanied by report cards reminding the customer of the “great” overall service and a few anecdotes of “heroic” service incidents.

Stumbling on Happiness also sheds light on a number of systematic errors and misperceptions that we naturally make in evaluating decisions and predicting how we will react to future events.

These factors are critical to the way we conduct our daily business, as well to the processes we use to frame and evaluate our major strategic moves. If we are aware of these tacit factors, we can take deliberate steps to significantly improve our performance. The key is awareness and understanding, and all at no cost.

Two New Articles – Profitability Without Pain, and Supply Chain Finance

In the past few weeks, Sloan Management Review published an article about my new book, and I wrote the lead article in CSCMP Supply Chain Quarterly. Here are links:

“Increasing Profits, Sans Pain” –  interview by Martha Mangelsdorf, Sloan Management Review, Winter 2011

“Join the Revolution” –  CSCMP Supply Chain Quarterly, Winter 2011

Please note that you can download the Sloan Management Review article from the link above.

The CSCMP (Council for Supply Chain Management Professionals) Supply Chain Quarterly article is only available to members and subscribers. The subject is how to successfully manage the revolutionary new possibilities in supply chain finance. The article describes how supply chain management has changed from a functional area primarily concerned with cost minimization and customer service, to one which can have a critical impact on all aspects of a company’s performance – revenues, costs, profitability, cash flow, asset productivity, and risk management. It gives a systematic step-by-step process for successfully improving company performance in all these areas.

I hope you find them interesting and helpful. If you would like to talk about either article, please send me a note to jlbyrnes@mit.edu.

Demand Management Disney Style

Many companies simply assume the seemingly obvious proposition that, to put it simply, demand is demand and their responsibility is to gear their operations to meet that demand. Certainly, most managers utilize advertising and specials to create demand and promote certain products, but these initiatives tend to be broadly aimed and not dynamic in nature.

A few very well run companies have learned how to manage demand in a dynamic, responsive way – at a very granular level – and to fit it to their supply. This gives them constantly full capacity, terrific customer satisfaction, and very consistently high levels of profitability.

Demand management is one of the most powerful profit levers, but surprisingly few managers consistently take advantage of it.

Disney’s demand management

Disney has a long history of effective demand management. Several years ago at MIT, we developed a workshop for executives of our affiliated companies on state-of-the-art customer service. The head of customer service at Disney World was among those presenting to the group. She described in detail how Disney has perfected both the art and science of customers service and effective demand management.

For example, Disney has done many careful studies of how long people will wait in line before they need to be distracted. Through these studies, they have determined exactly when to engage the waiting guests with wandering characters, videos, mirrors, and other measures. They also lay out their lines in a serpentine fashion so the guests can’t see how long the line really is, and so that they experience a feeling of constant progress.

A fascinating New York Times article published about a month ago explained how Disney has
continued to develop its techniques for demand management. Here are some of the key points:

  • Disney World has outfitted an underground nerve center with state of the art video cameras, computer programs, digital park maps, and other tools to detect waiting problems and deploy countermeasures in real time.
  • In an insightful move, the company outfitted the flat screen TVs in the nerve center with devices that depict the various attractions with green, yellow, and red outlines to represent wait time gradations.
  • If wait time is mounting, the center can alert the attraction to increase capacity (e.g. launch more boats), or dispatch a character to entertain the people waiting in line.
  • Alternatively, the operations center can route participatory mini-parades that guests can join toward attractions with shorter lines to siphon guests and balance capacity. Through these measures, Disney has significantly increased the average number of rides per visitor.
  • Underpinning Disney’s capacity management is a complex, computerized system that projects demand based on an analysis of hotel reservations, flight bookings, historical data, and even satellite weather information.
  • Disney is currently experimenting with smartphone aps that give directions to attractions and characters, and soon to the nearest restaurant with the shortest wait.
  • The company has also started adding video games to wait areas to further increase guest tolerance for long lines.

Disney managers have combined careful research, creative insight, and tailored technology to develop, deploy, and perfect measures like these. Through this process, they have met their primary objective of maximizing customer enjoyment, while at the same time fitting demand to their supply without the guests ever knowing it.

Dell’s demand management

Dell catapulted to prominence as a PC producer with its well-known direct model. This business model enabled Dell to effectively manage demand and fit it to its supply dynamically and in real time. Here are a few of the demand management techniques Dell developed.

  • Dell purposely selected customers with relatively predictable demand, especially corporate accounts, and avoided first-time buyers.
  • The company instituted a series of monthly and weekly meetings to match supply and demand, bringing these into alignment on an ongoing basis.
  • Dell’s managers developed daily processes to manage demand dynamically, and align it with supply. For example, if demand increased unexpectedly, purchasing could quickly shift to alternative suppliers. In addition, Dell’s sales managers gave the order takers incentives to shift customers to the makeable set of products (which were shown on their screens); the order takers also were encouraged to bundle available products with an attractive umbrella price.
  • The company changed its pricing on particular configurations daily to steer demand toward the available models.
  • Suppliers were selected based only 30% on cost, with the other 70% based on quality, service, and flexibility.
  • When in doubt, Dell’s managers over-forecast high-end products, because it was much easier to sell up, and high-end products had a higher shelf life.

These measures, and others, allowed Dell to systematically manage demand, and relentlessly fit it to its supply. (I describe Dell’s business model in more detail in my new book, Islands of Profit in a Sea of Red Ink.)

Management challenge

Note that Disney provides services, while Dell produces physical products. But both companies developed extremely effective processes that combined research, creative insights, and targeted technology to dynamically manage demand at a very granular level, and fit it to their supply. In the process, they maximized customer satisfaction while also maximizing their capacity utilization, asset productivity, and profitability.

Dynamic demand management at a granular level is one of the most powerful ways for a company to expand its islands of profitability, and to turn around the marginal business that constitutes its sea of red ink.

The challenge for all managers is to develop as a core business process the systematic knowledge, creative insights, and targeted technology that will enable them to constantly monitor their demand and fit it to their supply.

Those who do so will realize the twin objectives that mark the highest-performing companies: high levels of customer satisfaction along with sustained and growing profitability.

The Myth of the Operations Hero

Did you hear about the railroad operations manager who stayed up all night in a snowstorm helping right a derailed boxcar so the train could get through on time?

If you were running the railroad, what would you do –

(a) recognize him in a major company-wide event;

(b) reward him with a promotion; or,

(c) reprimand him and put him on disciplinary watch?

To most managers, (a) and (b) seem so obvious that it appears to be a silly question. But is it really?

I recall working with the top management team of a major US railroad a few years ago. The company was emerging from a difficult period characterized by chronic service problems. In this context, the operations managers like the one described above were treated as heroes. They embodied the values prized by the organization – tough, persistent, and effective. These were the managers that were celebrated and promoted.

But when I probed the situation more deeply with the top managers, it became clear that the real underlying problem was that the operations heroes had not done a good job of day-to-day maintenance and all the other mundane tasks that would have prevented the crisis. By celebrating the heroic response, the company’s top management team was in essence telling the organization that it was OK to skimp on the quiet, unobserved day-to-day work, as long as they responded forcefully to the problems that inevitably resulted.

They were communicating that crisis response is more important than crisis prevention.

I saw the same thing in telecom several years ago. When a line was out, a trouble report quickly went up the management hierarchy. If not fixed in a matter of hours, the report landed on a vice president’s desk. Just like the railroad. In this context, the manager who braved the elements to fix the line was a hero, even though the real issue most often was a lack of effective preventative maintenance.

The real problem

Both the railroad and the telecom company subsequently installed new operations management teams that instituted operations reorganizations. These new top managers understood the importance of crisis prevention, and developed a new focus on appropriate actions and metrics.

It was very difficult for these top managers to change their respective companies’ culture. One of the biggest problems was that the middle and upper-middle managers who were in place had been promoted for crisis management. They were not skilled in crisis prevention, and importantly, their personalities were more suited for the action-oriented crisis response than for the more systematic and analytical process of crisis prevention.

In both cases it took years to turn around the operations through a combination of steady knowledge development, comprehensive training, and slow change-out of the prior management team.

To the credit of both companies, the top operations managers of both companies were persistent, effective, and ultimately very successful.

The sales hero

A similar problem arises in sales and account management. When a major customer has a problem, the fire bell rings and everyone rushes to respond. The sales manager who saves the account relationship is celebrated as a hero, often slated for promotion. By contrast, the sales reps who are skilled at maintaining and slowly growing major accounts often remain in the shadows.

In the most effective companies, however, top sales leaders understand the process of quiet, steady account development. This involves mapping the customer’s buying center, understanding how to increase the customer’s profitability, and seamlessly involving operations managers with their customer counterparts to reduce the costs for both customer and supplier. This is a long, steady process, but it creates customer relationships with high sustainable profitability and growth.

It also leads to the question: who is the real sales hero? And to this question: are these operations managers – the ones who quietly drive major sales increases and cost reductions – the real operations heroes?

Profitability heroes

I was reminded of these questions a few weeks ago when I spoke to a joint MIT – Harvard alumni event in Jacksonville. The subject of my talk was “How to Lead a Profitability Turnaround,” and I was asked a question on how to be an effective transformational leader.

When I thought about it, it seemed that most of the images of a turnaround leader conjured up a “man (or woman) on horseback” like Teddy Roosevelt leading his rough riders in the charge up San Juan Hill. The action-oriented crisis manager – celebrated for his success. Like the operations hero.

In my experience, most of these “heroes” are skillfully (or not so skillfully) managing a crisis that was avoidable. In most cases, their companies were suffering through a very painful transition period that really should not have occurred.

The real profitability heroes are the managers who have the wisdom and insight to develop systematic information, processes, and behavioral drivers that enable their managers to coordinate with each other to achieve more and more profitability. With this in place, their management teams naturally form effective coordinative processes and a culture of profitability.

Effective transformational leadership is not at all like leading the charge up San Juan Hill. It is much more like deciding to get healthy by eating better and getting regular exercise. Not dramatic, not romantic, not exciting – just very, very effective.

Top management choice

One of the truisms of management is that – as in teaching – you get what you expect. If you celebrate the mythical operations heroes, sales heroes, and profitability turnaround heroes, you will get mediocre performance punctuated by occasional flashy displays.

But if you have the foresight to systematically create the conditions that enable your managers to inexorably increase performance and prevent crises, you will get consistent excellence that exceeds even your most optimistic hopes.