Holiday Greetings!

Dear friends and colleagues,

I am writing at this very special time of year to thank you for bringing happiness and meaning into my life in so many ways.

I am grateful that so many of you are the source of so many terrific ideas that I write about, and that you share your reactions in ways that encourage me to stretch my understanding.

I am grateful that so many of you give me the deep joy of teaching –  as students, as executives, and as alumni. Most of all, I am grateful that you allow me to stay in touch with you, and experience the great pleasure of seeing you grow and succeed.

I am grateful that I have been able to volunteer for years in alumni affairs, meeting and becoming good friends with so many great people.

I am grateful that so many of you are wonderful friends, often for decades, sharing both joy and sadness, but always deepening our lives with caring.

And, I am grateful to my family for giving me the ultimate happiness in life. I am especially grateful beyond words to my wife, Marsha, for being the blessing of my life since we met in Cambridge 37 years ago.

Marsha joins me in wishing you and your families a wonderful holiday season and a new year full of peace and blessings.

Jonathan

Pictured: Kristin, Dan, Marsha, Jonathan, Steve, Nicole

How to Win the Battle and Lose the War

Sunday, December 7th, 1941. Admiral Chester Nimitz was attending a concert in Washington D.C. He was paged and told there was a phone call for him. When he answered the phone, it was President Franklin Delano Roosevelt on the phone.

He told Admiral Nimitz that he (Nimitz) would now be Commander of the Pacific Fleet. Admiral Nimitz flew to Hawaii to assume command of the Pacific Fleet. He landed at Pearl Harbor on Christmas Eve, 1941. There was a spirit of despair, dejection, and defeat, as if the United States had already lost the war.

On Christmas day, 1941, Admiral Nimitz was given a boat tour of the destruction wrought on Pearl Harbor. Big sunken battleships and navy vessels cluttered the waters. As the tour boat returned to dock, the young helmsman of the boat asked, “Well, Admiral, what do you think after seeing all this destruction?”

Admiral Nimitz’s reply shocked everyone. “The Japanese made three of the biggest mistakes an attack force could ever make, or God was taking care of America. Which do you think it was?”

Shocked and surprised, the helmsman asked, “What do you mean by saying the Japanese made three of the biggest mistakes an attack force could ever make?” Nimitz explained:

Mistake number one: the Japanese attacked on Sunday morning. Nine out of ten crewmen of those ships were ashore on leave. If those same ships had been lured to sea and been sunk, we would have lost 38,000 men, instead of 3,800.

Mistake number two: when the Japanese saw all those battleships lined in a row, they got so carried away sinking those battleships, they never once bombed our dry docks opposite those ships. If they had destroyed our dry docks, we would have had to tow every one of those ships to the mainland to be repaired.

As it is now, they are in shallow water, and can be raised. One tug can pull them over to the dry docks, and we can have them repaired and at sea by the time we could have towed them to the mainland. And I already have crews ashore anxious to man those ships.

Mistake number three: every drop of fuel in the Pacific theater of war is on top of the ground in storage tanks five miles away over that hill. One attack plane could have strafed those tanks and destroyed our fuel supply.

That’s why I say the Japanese made three of the biggest mistakes an attack force could make, or God was taking care of America.

My friend and classmate, Fred Hooper, sent me this story. Supposedly it came from a book that Admiral Nimitz wrote, which is now out of print. Whether it is factual or merely a very compelling urban legend, the story offers important strategic lessons.

Strategic lessons

I thought about this anecdote during a recent meeting. I was reviewing a company’s situation with one of its top officers. A competitor had developed an innovation and was deploying it rapidly. The action question was how the company should respond.

The seemingly obvious answer was to pick up the pace and try to match the competitor. When I thought about how other companies I had worked with had responded in similar situations, two things became clear: (1) the competitor had indeed made tactical gains that raised concerns, but (2) it was not at all clear that this innovation would produce a clear long-term strategic win.

The answer was to look very carefully at the customer value proposition that the tactical initiative created, and to set this against the broader opportunity to develop a more sweeping, strategic value proposition. Was the tactical initiative a long-term win strategy, or merely a short-term gain?

Would it win the battle, or win the war?

What’s especially interesting about this situation, and so many others like it, is that the rush of events – the concerns about keeping up with a competitor’s tactics, or, conversely, enjoying the satisfaction of tactical gains –  can essentially blind a company’s management team to the broader, more subtle opportunities to develop a truly creative, compelling strategic partnership.

Worse, managers all too often feel that they don’t have time to concentrate systematically on the deeper, more subtle opportunities because they are so busy trying to keep up in the tactical battles.

In short, most managers instinctively focus on how to win the battle, rather than how to win the war.

Three steps

How can a management team shift perspective from winning the battle to winning the war? Three steps are essential.

First, walk in your customer’s shoes. There is no better way to build a powerful customer value proposition than to spend significant time physically in a set of customers. The objective is to watch the entire purchase/use cycle for your products. This includes everything from selecting the products, to obtaining them economically, to understanding how to use them.

Here, you are looking for opportunities to build the broadest, most powerful value proposition by expanding your extended product (the full set of activities that relate to the purchase and use of your product). The early development of innovations like vendor-managed inventory and category management provide examples. (For more on this, see my blog post,  Turbocharge Your Value Proposition).

Importantly, building your extended product can offer the opportunity to create compelling value in unexpected ways.

Think about Nalco, a company that provides chemicals to water treatment systems. It installed sensors in the chemical tanks on customer premises. This enabled Nalco to be much more efficient at replenishment and production. But the company didn’t stop there.

Nalco’s managers realized that this innovation allowed it to monitor the actual rate of chemical draw-down, and compare it to the expected rate if the system were operating at peak efficiency. When the Nalco engineers saw a variance, they would call the water system’s managers and alert them to adjust the system. This routinely led to customer savings many times the cost of the chemicals.

In the process, it made Nalco indispensible – transforming the company’s positioning from commodity supplier to essential strategic partner. I think of this as drawing a bigger box around your business.

Here’s my take on the ultimate truth in business: you always have an opportunity to increase your value footprint, and real value always wins.

Second, always move toward the middle. When I was young, I read a book on how to win at checkers. What I remember to this day is that if you are in doubt about what to do, move toward the middle of the board. This is how you develop a dominant board position.

In fact, the classic rookie move in chess is to go for checkmate on an early move, instead of laying out your board position.

What is the equivalent of board position in a supplier-customer relationship? In a nutshell: real value and trust. Once you have worked to understand and develop a truly winning value proposition with a very creative extended product, the next essential task is to systematically put the core pieces in place. And, often the core pieces are subtle.

For example, suppose a supplier wants to develop a highly integrated supply chain with a major customer, and the customer is not interested in this type of relationship. What should the supplier do?

Here, the core building blocks, as always, are real value and trust.

Even with an arm’s length relationship, the supplier can arrange for its operations managers to meet periodically with their counterparts in the customer. Over time, the supplier’s operations managers will develop a trusting relationship with their customer counterparts. Note that this process does not focus on selling products or solving problems, only building trust.

Later, once the trusting relationships have developed, the operations managers can bring the customer counterparts to meet operations managers in other customers that already have productive, highly integrated supply chains with the vendor. These meetings will naturally gravitate toward identification and  confirmation of the value produced.

Through this process, the supplier can build the essential core of real value and trust that will lead to a highly productive, and highly differentiated, relationship with the target account.

Contrast this with another supplier that might instead focus on tactical gains like merely expanding the product portfolio sold to the customer. This supplier might win the battle, but would surely lose the war.

Third, touch the dream. Every top manager in every company has a dream – a vision of what real success looks like. This nearly always centers on business growth and creative new business initiatives.

When your value proposition enables your customers to move toward their dreams, you will be an essential strategic partner. You will win the war.

This can happen in unexpected ways. For example, I’m deeply familiar with the operations of a number of vendor-managed inventory systems and other supply chain innovations. These certainly create important benefits, including customer cost reductions. But surprisingly often, the most powerful, but unexpected, benefit is that the partnership enables the customer to enter new markets or offer new services because it can draw on the supplier partner’s deep, specialized capabilities.

By enabling the customer to grow its business in powerful new ways that the customer alone could not have done, the supplier becomes an essential part of the customer’s success. The supplier wins the war by touching the customer’s dream.

Win the war

It is so tempting to operate close to the surface of a customer relationship, focusing primarily on the day-to-day sale of your products and services, searching out tactical gains. And, if you do achieve tactical gains, it is overwhelmingly tempting to focus on accelerating your “victories.”

However, the top managers that succeed in the long-run have the discipline to remain focused on understanding and developing the most powerful customer value proposition. When they have created this understanding, they redouble their efforts to push the value creation envelope even further – continuing to search relentlessly for new ways to create real value and trust.

I’m reminded of a wonderful exhibit mounted several years ago by the Smithsonian Institution on American Ingenuity: If We’re So Good, Why Aren’t We Better?

The best managers in the best companies are always relentlessly focused on this question, and almost frantic to find an even better answer. This is how they got to be market leaders, and this is why they stay in front.

What is the ultimate secret to success? Remember Admiral Nimitz, and don’t be satisfied with anything less than winning the war.

New Ten-Minute Video – Finding Islands of Profit in a Sea of Red Ink

In this 10-minute video, Finding Islands of Profit in a Sea of Red Ink, I discuss the enormous opportunities for profit generation today, the sweeping transformation currently occurring in business, and how managers can succeed in this new era.

Here is the link to the video:

http://www.dcvelocity.com/dcvtv/viewercontributed/1288398437001/

I hope you find it helpful.

Profitability FAQ

A year ago, my new book, Islands of Profit in a Sea of Red Ink, was published. Since then, it was named a best book of 2010 by Inc, and many companies have purchased copies for their top management team. Here are fifteen key questions – with brief answers –  that managers have asked me.

Why is 40% of most businesses unprofitable?

All of our management information and processes were developed in a prior business era. Our accounting categories are too broad to see which accounts and products are profitable and which aren’t – so people simply assume that more revenues equals more profits. Some revenues are very profitable, and a surprising portion produce big losses. In virtually all companies, no one is responsible for monitoring and managing the interaction of revenues and costs at the grass-roots level to maximize profits.

How do top managers react to this?

They strongly agree. In years of writing about this in Harvard Business School’s Working Knowledge e-newsletter and website, no one has disagreed. When I speak to top managers about this at MIT and in my consulting clients, no one disagrees. The problem is that they don’t know what to do about it, and they are rightly concerned that just “firing bad customers” (wrong thing to do) will hurt their stock price.

How can this be fixed?

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.

Why is your advice particularly important in our current economy?

Today is prime time for rapid improvements. Customers are desperate for new ways to get better, and they’re very receptive to trying new ways of doing things. Most competitors are frozen in the headlights trying to cut costs indiscriminately. The key is to focus on growing the 20-30% of your company that can give you high sustained profitability, and then get more high-potential business that fits. You’ll rarely have this great an opportunity to lock in the best business – just stop wasting good resources on business that will never generate profits.

Why are so many companies today meeting their sales targets but still losing money?

Because 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. Everyone looks at the improvement and celebrates. But 10% better than last year, and just as good as the competition is simply not good enough.

What are the most common mistakes businesses are making that prevent them from being consistently as profitable as possible?

Three big mistakes: (1) assuming that more revenues means more profits; (2) failing to focus attention and resources on securing and growing the business that produces high sustained profitability –  this makes a company vulnerable to focused competitors and reduces reported profits; and (3) failing to put anyone in charge of maximizing account and product profitability at the grassroots level (in contrast with putting lots of people in charge of managing budgets).

What is “the age of precision markets” that we have entered?

In the prior “age of mass markets,” companies sought the economies of scale of mass production, coupled with mass distribution using arm’s length customer relationships. In that era, more revenues really did mean lower costs and more profits. In today’s “age of precision markets,” companies form different relationships with different sets of customers, each with different costs and profits. Yet, virtually all of our management information and processes were developed in the prior era, when all revenues really were equally desirable. This is the underlying reason why almost every company has so much embedded unprofitability and why so many managers fail to see and build their sustainably profitable core of business.

How should the role of the CFO change to adapt to today’s new economic conditions?

In these difficult and uncertain economic times, companies need broad-gauge, strategic CFOs. An effective CFO must be able to chart a course to sustainable profitability and growth,  and orchestrate the company’s functional managers to accomplish this objective. This process goes far beyond managing operating efficiencies, cash flows, and budgets. It involves three essential elements: (1) profit mapping – moving beyond our traditional, overly broad, aggregated accounting measures to construct a granular transaction-based picture of account and product profitability; (2) sustainability – identifying the 30-40% of the company that is unprofitable, and more importantly, the 20-30% that is capable of strong sustainable profitability and growth, even in tough times; and (3) driving performance – identifying and prioritizing the key initiatives that will cement and grow the sustainably profitable portion of the business.

Should your advice be adapted differently when we’re in a recession vs. when we start recovering?

The management to-do list is the same, but the distractions are different. In a recession, there is an overwhelming instinct to cut costs across the board and to hoard cash. This is exactly the wrong thing to do. Instead managers should step on the gas –  identify and grow the sustainably profitable portion of their business by focusing their resources and investments on these customer relationships. When times improve and all ships rise on the incoming tide, the instinct is to cling to all revenue increases – no matter what the profit impact. Rather, managers should shift their resources to the business that produces high sustainable profits and growth.

How can a company’s sales force become more profit focused?

Four key elements: (1) know the score – both account potential and profitability; (2) know the priorities – secure the best (most profitable) accounts, then get more of the best business, then turn around the marginal business, and lastly reprice the remaining losing business; (3) know the company’s best practice – observe the president’s club winners’ best practices, codify them, and teach them to the others (especially the critical task of ramping up high-potential underpenetrated accounts); and (4) know how to link sales compensation to profitability, not just to revenues and gross margins. Note that these are top management’s responsibility – how can a sales rep maximize profitability if the company’s top managers don’t know how to do it?

How can you make your customers more profitable?

If your operations managers can’t tell you what they would do to maximize a key customer’s profitability, they need to spend much more time in their customers – walking in their customers’ shoes. (Note that I said operations managers, not sales reps.) They need to work directly with their customer counterparts to develop three things: (1) great rapport, relationships, and trust; (2) a joint end-to-end understanding of the activities and costs of the intercompany supply chain – and an agreement on how to lower costs and increase asset productivity for both companies; and (3) an understanding of the political situation and attitudes of the members of the customer’s buying center. These three things will drive huge sales and profit increases, even in highly penetrated customers. Unfortunately, most managers incorrectly assume that operations managers should only meet with customers after a mature sales relationship is established.

How should supply chain management be adapted to be more profitable?

Supply chain managers should have a critical role but are in danger of being bypassed. Traditionally supply chain managers focused primarily on internal cost reduction, an artifact of the age of mass markets. Today, they have to shift focus to supply chain productivity, which involves four critical tasks: (1) understanding and maximizing the earnings of their assets, not just minimizing costs; (2) spending a large portion of their time with their counterparts in key customers (those capable of providing high sustained profitability and growth) in order to figure out how to drive sales by making the customers more profitable; (3) working with the sales and marketing team to develop a standard set of customer relationships (arm’s length to highly integrated), so they can fulfill each in a streamlined and economical way; and (4) teaming with sales and marketing to match customers to relationships.

How should marketing be adapted to be more profitable?

At budget time in many companies, the marketing group gets concerned about quantifying its value-added. Yet marketing is at the center of two critical profitability variables – customer relationships and product development. Customer relationships are the key to securing and growing profitable revenues. Marketing should lead the way in developing a standard set of relationships (from arm’s length to highly integrated), matching customers to relationships, and establishing relationship migration paths to deepen key account integration. The key to effective product development is to meet the needs of the customers in the core of sustainably profitable business, rather than designing products for the average customer. By excelling in these two critical areas, marketing managers can make a huge lasting contribution to profitability.

Does profitability require a different sort of leadership?

Yes, everyone has to manage at the right level. Vice presidents should spend most of their time positioning the company for the next 3-5 years – since that’s the time it takes to develop major new initiatives. Directors (department heads) should spend half their time coordinating with each other to manage the company’s profitability, and the other half directing the managers who report to them. Managers should run the day-to-day company. Instead, in many companies, everyone focuses primarily on the company’s day-to-day performance.

What are the first steps anyone can start taking tomorrow to make their business more consistently profitable in today’s economy?

A small team of managers can analyze the profitability of a multi-billion dollar company at a very granular level in several weeks using standard desktop tools. This is the first step. With this view, the management team can develop a highly targeted set of initiatives to secure and grow the best business, and to turn around the marginal business. Within a year, the company will experience a dramatic, sustainable increase in profitability.

Profit Pitfalls

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:

  • Contribution – Why shouldn’t we take business that contributes to overhead, even if it doesn’t cover full cost?
  • 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 products if they attract customers who then buy very lucrative products so we make money overall?

Each of these questions seems to have a perfectly logical answer that leads to the suggestion that it is OK to carry money-losing business. Maybe, the Sea of Red Ink is not so bad after all.

But think about each question carefully.

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? 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 throw out 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 “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, some not. This is the source of the Sea of Red Ink.

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: Islands of Profit in a Sea of Red Ink. And no one knows where it came from.

Product line

The second profit pitfall also seems to have an unassailable logic. Since 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 product line overall.

This seems completely logical. But think about it carefully.

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.

I can understand this thought process – but it only makes sense if the company calculates the return on this investment, and shows that it is a good investment. How many companies do this?

The counter argument is that it is impossible to do this calculation. However, with a profit map, showing the net profitability of every product in every account – and every account’s buying pattern – you can quickly make this determination. (I explain how to build a profit map in my book, Islands of Profit in a Sea of Red Ink.)

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 decade or two shows that many very successful companies like Wal-Mart do very well by positioning themselves selectively in key product categories, and competing on price. It goes without saying that the rock-bottom low prices are generated by streamlining the supply chain and eliminating the extraneous 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, 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. 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 – if you have a profit map 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 favored customer category.

This is the power of profit mapping in action.

Traffic drivers

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

Your product 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.

Think about consumer electronics. The new DVDs and CDs hit the shelves on a certain day, and the consumer interest plus attractive pricing generates a lot of business. The retailer may be losing money on this category, but the logic is that the company will make it up in other high-margin purchases.

Almost every supplier has business that looks like this.

When you think carefully about this product strategy, it 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 how many companies actually track this in order to determine the real return on investment? In practice, very few.

As in the case of the product line profitability, a profit map 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 has a reasonable-sounding logic. The really big issue, however, is determining where the logic produces sound 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 profit mapping is that it allows you to draw a line in the sand, and make this precise distinction.

In this way, profit mapping enables you to build your Islands of Profit, while at the same time draining your Sea of Red Ink.