Profitability Analysis:Focusing on the Right Performance Measures in a Turnaround

Written by:Mohsin Y. Meghji

In the majority of companies facing financial distress, management is frequently the last to recognize the cause of the company’s underlying problems. Why? The answer often lies in the fact that management was not focused on the right performance measures. Specific examples of this are plenty and cover various industries:

• The retailer who did not understand that a significant number of its store locations were unprofitable as management was too busy increasing the number of locations rather than focusing on monitoring the right performance measures and taking decisive action to deal with under-performing stores.
• The wholesale distributor that was too focused on increasing its sales to its largest few customers who continually kept asking for and receiving pricing and payment concessions until they became the least profitable customers of the company.
• The manufacturer that did not realize that half of its product lines were marginal or negative contributors and did not have a disciplined approach to monitoring which products its sales force should be focused on selling.

The task of successfully implementing a long-term turnaround strategy is a difficult one. One of the most challenging issues involved is determining the exact causes of financial difficulty in any individual case.

Without being able to pinpoint the specific causes, it is impossible to identify a solution for the company’s problems.

This article reviews a useful financial diagnostic tool that may be used to target the specific causes of a company’s problems.

Profitability Analysis

One of the most effective tools for identifying (or confirming) a distressed company’s underlying problems is a profitability analysis. Depending on the industry, a profitability analysis could be performed by:

• customer
• product, and/or
• location

An ideal outcome of this type of analyses is one where the results fall under the "80:20" rule. If 20% of a distressed company’s customers, products or locations accounted for 80% of its losses then one could reasonably shed these and continue with the remainder, presumably on a profitable basis after additional operational improvements.

The major steps involved in performing a profitability analysis are as follows:

1. Gather Financial Information

A profitability analysis starts with gathering pertinent, accurate, and timely information. Sales by location, product, or customer must be obtained from the company’s financial statements and supporting management information systems. It is important to sort out all expenses to determine which are direct expenses particular to the product, location, or customer, allocable based on work load, usage, or some other logical basis, or accumulated centrally for the benefit of the total company and then allocated based on certain criteria.

By determining whether the costs are accurately accounted for, a comparison between product, customer or facility costs may point to a specific cost that needs attention.

2. Identify Key Performance Measures

The financial and other quantitative information will be used to establish key measures used in the analysis. These may vary depending on the nature of the business and industry. Key measures for the health care services industry, for instance, may be occupancy rates, profitability by payor or customer, and profit margins. A retail company may want to analyze average weekly sales, profit margins, average order size or high versus low volume categories. A manufacturing company may look at turnover rates, capacity, utilization, or production backlogs. These key measures must be carefully identified to accurately reflect the drivers of the product, customer or branch profitability.

3. Set Performance Benchmarks

The ultimate goal in a profitability analysis is to use comparable information to identify products, customers or locations that are under-performing and then make sensible decisions that will increase the overall profitability of the company.

Accordingly, it is important to set minimum performance criteria for each of the key performance measures identified for the products, customers, or facilities. These thresholds should consider factors such as a minimum tolerable contribution margins necessary to fund corporate overhead, debt service, capital expenditures and shareholder returns. A minimum return on working capital invested should also be considered. Even if a product or facility is profitable, it may not be contributing a certain minimum return. It may therefore be in the company’s best interest, then, to commit its capital elsewhere.

Performance benchmarks may be set up in several ways. One method is to create a "model store" or "model customer base". This model is especially effective with a branch or location profitability analysis. This threshold should reflect a minimum standard of performance. Locations meeting or exceeding this performance level should generate earnings and cash flow that, together with all other stores, would achieve management’s long-term performance objectives.

Another method of making decisions based on profitability is the "break-even" method. This threshold maintains that "the store’s earnings, at a minimum, are sufficient to fund the cost or working capital deployed". The stores or products which are just hitting the break-even point may continue operating as they are not negatively contributing to the company; however, they should be subject to further analysis as operational improvements may be possible. The company should consider discontinuing those that are not meeting working capital requirements.

4. Identify Problem Customers, Products and Locations

The profitability analysis will evaluate performance levels based on the minimum criteria and then categorize the segments as (i) good and therefore retained; (ii)"watch listed" and therefore requiring further evaluation or monitoring; or (iii) poor and therefore candidates for closure or discontinuation.

The company must rank the product lines, customers or branches from greatest loss to greatest contribution. This will allow management to focus on poor performers and make decisions accordingly.

5. Look for Trends and Unusual Items

One consideration when making decisions is to look for trends within a particular store, product or customer group. Trends will indicate whether the product, customer or branch is consistently failing to make positive contributions and whether the trend is improving or deteriorating. It is important, if looking at a year’s profitability, for example, that one particular period of time did not include any non-recurring items. An extraordinary expense may have been incurred at a specific facility or with a particular customer group that could skew the actual operating profits and would need to be adjusted. Trends in a detailed profitability analysis will highlight where the real problem lies, whether it be for example relatively high labor expenses in a particular facility due to unnecessary overtime charges or diminishing order size for a particular customer type.

 

 

6. Identifying Future Strategy

Once the underlying causes for an under-performing product, customer or branch have been identified, an effective strategy can then be developed. Marketing strategies, cost reduction strategies, and product realignment, to name a few, must be developed that are profit focused. The company should rid itself of any product line, customer group, or location that is not a minimum-level positive contributor to the company’s overall financial goals.

Solutions to an unprofitable customer or product may focus on improved marketing management. The company could re-assess product pricing practices, improve customer and distribution mix, improve sales and marketing productivity and effectiveness, and improve profit per customer.

Improving profitability of a facility or product may also require a focus on manufacturing and operations management. Ongoing productivity improvement programs need to be developed, cost systems that follow cost causes may be used (such as activity-based costing), overhead value analysis should be periodically done and ongoing profit improvement programs must be put in place.

7. Other considerations

Several other issues must be considered when deciding the appropriate strategy to increase profitability. The expected return on additional investment should be considered. Capital expenditures to remodel a location for example must be evaluated in conjunction with the projected sales and margin growth. Investing in remodeling a facility may not be an option though, depending on the critical cash position of the company. In the retail industry, for instance, facilities many times hold significant amounts of inventory. The cost of holding these inventories should be taken into account during the review process. Other areas to investigate when deciding to continue or discontinue a branch are closing costs, the effect on pricing due to volume reduction with vendors, lease contracts, and competition.

Challenges in this Process

Persistence is a required trait for turnaround consultants and crisis managers and it is very helpful in this process. Many distressed companies initially resist this process as it goes entirely "against the grain" of what they believe they should be doing. Accordingly, it can be a slow and difficult process initially.

The availability of reliable adequate information is also generally a challenge through this process. Reliable industry benchmarking data may also not be readily available or may not be directly comparable. Many companies in the same industry, can have entirely different views of what constitutes overhead versus variable costs. Cost allocation methodologies may vary significantly from company to company which adds another level of complication to the process.

However, in most instances the payoffs and benefits of this process far exceed the costs, if properly executed.