6 Tactics to Improve Unit Margins

In short:

• CFOs may find themselves in the unenviable position of being “the profit police.” It’s a tough job, but someone has to do it.
• Runways are calculated and recovery scenarios rated based on probabilities. Finance teams are in a position to determine if what was making money pre-pandemic still pays.
• Carefully conserving cash while maximizing adjusted unit profitability gives your company the gift of breathing room.

Companies are using a grab bag of pricing tactics to adapt to a new business landscape. One best practice that may have fallen by the wayside, however, is monitoring profitability ratios.

CFOs need to ask: Have recent changes to staffing, raw material pricing, supply chains, our underlying business model or other factors affected margins, positively or negatively, in a way that will have implications next year and beyond?

It’s a timely question. The price of oil is up significantly, and the U.S. Bureau of Labor Statistics says April brought the sharpest increase in food prices in nearly 50 years, further impacting grocers and restaurants — not to mention consumer disposable income. The agency’s June report shows prices of nonresidential construction materials up an average of 2.3%.

Meanwhile, sales teams worried about making quarterly numbers may be agitating to cut deals.

“Whether you’re considering price reductions, or providing added-value services to existing customers at no cost, or simply extending credit terms as an olive branch of solidarity, spend some time considering how these decisions might impact your business in the longer term,” said Joanne Griffin, founder and CEO of AdaptIQ, a consulting firm that advises clients on adaptability strategies.

Two adaptations to avoid: Managing for cash flow at the expense of profitability and letting sales teams provide steep discounts with the expectation that you can execute an about-face when conditions improve.

It’s extremely difficult to come back from over-discounting, so instead of quickly resorting to price slashing, first consider upgrades, value-added services or relaxed payment terms. Otherwise, when you eventually need to bring prices back to levels that provide profitability, you risk losing customers. And that’s expensive — acquiring a new customer is generally viewed as five to twenty-five times more costly than maintaining an existing relationship.

While timing the recovery is an iffy business right now, one thing we can say is that chipping away at profit margins will shorten your runway. CFOs should work with sales leaders to figure out how to balance the needs of the business while retaining current customers, who, if handled well during difficult times, provide great references and are more apt to adopt additional products.

When deciding what price reductions or extended payment terms are affordable, run revised profitability ratio and lifetime value/customer acquisition cost (LTV:CAC) calculations. Also state in writing how long you’ll maintain any price breaks.

Look Ahead

Economic dislocations create opportunities for financially disciplined companies to leapfrog competitors. Financial discipline means paying attention to unit economics and stabilizing profits where demand exists. The other part of that equation is to grow new revenue streams where demand looks likely soon.

That requires two actions: Do a full profitability analysis of your core products and services so you know where to invest, and accelerate your visioning and strategic planning process.

Pricing to maintain margin is difficult when customer demand is unpredictable, raw material costs are rising and you’re being hit with unforeseen expenses like retrofitting locations for safety. Maintaining an appropriate utilization across the organization and tracking project-by-project profitability helps ensure that your overall gross profit margin as a company stays on track.

What’s “on track” look like? Our own analysis provides some baselines: For an ad agency, 32%. Retailers should aim for 28%, while wholesale distributors are closer to 10%. Those numbers are based on Brainyard’s industry-specific KPIs, which are drawn from anonymized and aggregated usage data from some 21,000 NetSuite customers.

Besides making gross profit margin adjustments, in light of the potentially higher cost of goods sold; lower sales volume or pricing pressure; and some entirely new KPIs CFOs are watching, like PPP loans received and whether they can be converted to grants, refocus on operations and DSO:

Operating margin/return on sales: Operating margin is the definition of profitability. OM takes into account indirect business expenses, aka overhead — which has likely changed in the past quarter. If you’ve shifted employees to work from home, you may be saving on utilities but spending more on IT support. We recommend tracking the per-employee costs associated with various work scenarios.

ROS measures both efficiency and profitability. Retailers and distributors dealing with a flood of returns need to work on their reverse-logistics processes.

Days sales outstanding: How many days, on average, does it take your customers to pay invoices now versus six months ago? DSO illustrates how your receivables are being managed. High DSO equals low cash flow and indicates a need to better manage liquidity.

DSO also spotlights unprofitable customers.

“This opportunity has enabled savvier companies to stand back, reassess and intensify focus on the more profitable markets and offerings,” said Mark Faust, a growth adviser at Echelon Management International. “Prioritize your customers and offerings in order of profitability. Draw a new line of what you will not sell, and multiply your efforts in the most profitable areas.”

Beyond prioritizing product focus by margin, keep a firm hand on cash management so that your business can respond to new opportunities. Yes, that’s easier said than done, but there are best practices for maximizing liquidity.

“I see a lot of great finance leaders in ‘paralysis’ mode right at the very moment you need to engage your brain’s fullest capacity for rational decision-making,” said AdaptIQ’s Griffin.

Moving beyond analysis paralysis is imperative to grow new revenue streams when you spot demand.

“CFOs must invest time and resources in building strong, flexible and responsive financial models to underpin rapid forecasting of alternative outcomes,” said Griffin. “Improving the frequency of financial modelling, alongside expanding that model to incorporate a wide range of potential outcomes, ensures that the business remains focused on rapidly adapting to emerging trends as they occur.”

Companies that emerge from the pandemic stronger will be those that stayed disciplined on spending and maintained margins. Cash equals agility.

“Being in a strong cash position not only smooths out the inevitable economic bumps in the road, but also allows for companies to seize opportunities,” said Edward Hatfield, CFO at Boost&Co, a UK-based independent asset manager specializing in growth-lending services and venture funding.

6 Steps to Ensure Profitability

While every business has unique financial circumstances, resiliency levels, risk tolerances and goals, there are some common steps that CFOs can use to shape their profitability plans. Below are among the top considerations:

Always start at the top line. Closely examine your customer base and honestly evaluate your vertical and specific-customer exposures to determine the total dollar value of revenue at risk. Look to your data to identify and act on trends in consumer demand, customer behaviors and industry shifts that directly impact your top line. Be realistic about the health of your customer base. Do not waste time aggressively pursuing new customers that have fundamentals stacked against them.

Reevaluate expenses line by line. Travel costs are a prime example since employees either are not travelling on business now, or they are doing extraordinarily little of it. What can you learn from this experience in terms of what travel is essential to the business? Then there’s real estate. Morgan Stanley and Barclays have stated that they will dramatically shrink their office footprints, and plenty of small to midsize firms are likewise reconsidering their commercial real estate needs for the foreseeable future. We have advice for negotiating with landlords.

Shorten capital-in-progress timelines. Every CFO keeps track of capital-in-progress, also known as capital work in progress, as an indicator of where cash in the business is tied up. It exists as an asset account on the balance sheet and is used to record current costs related to long-term projects.

“Companies with deep visibility into their supply chains see where delays or shortages are and shorten that capital in progress timeline by redistributing resources from locations with extra on hand or where it’s not yet needed to locations that are experiencing delays in receiving materials and equipment,” said Mahesh Veerina, CEO at Cloudleaf, which works to optimize logistics and add visibility to supply chains. “This frees up capital more quickly and puts that revenue back into the company’s profits.”

Related, make working capital work harder. “Understanding changes in cash flow patterns, and what they mean for your business, can help you release excess cash within your working capital,” said Griffin. A robust cash-flow forecasting model can release excess cash tied up in receivables or stock and minimize supply chain risk.

Renegotiate contracts. Odds are that your company has done some of this already in order to pause or lower some cost commitments in the short-term. Now it’s time to revisit all contracts to capture longer-term savings. One example: Reconsider office equipment leases and managed services contracts if you plan to keep some or all employees working from home for the foreseeable future. Comb through contracts with an eye to reducing COGS. Are there suppliers that will offer a price break in return for signing a longer-term contract? Reach out — there may be areas to negotiate a tradeoff as companies’ relative priorities differ.

Manage profits versus customer expectations. For years now, companies have focused on improving the customer experience, and that ethos must stay in place to remain competitive. However, now more than ever, it may be necessary to tell customers or clients “no” on occasion, too.

Develop policies on discounting centered on profitability, and make sure all salespeople know the parameters. That will plug money drains and help avoid backlash when you eventually need to reset prices. As Brainyard editor Art Wittmann recently pointed out, CFOs need to know when to say “show me the receipts” by insisting that department heads back up claims about sales, production — or anything else — with data.

Question the status quo. “Embrace the unease associated with the uncertainty about the future,” said Griffin. “Channel your survival anxiety to fuel your unlearning. Question the assumptions in your business model, prepare multiple scenarios, and have Plan B, C and D at hand to face this period of unprecedented ambiguity.”

A prolific writer and analyst, Pam Baker’s published work appears in many leading print and online publications including Security Boulevard, PCMag, Institutional Investor magazine, CIO, TechTarget, Linux.com and InformationWeek, as well as many others. Her latest book is ”Data Divination: Big Data Strategies.” She’s also a popular speaker at technology conferences as well as specialty conferences such as the Excellence in Journalism events and a medical research and healthcare event at the NY Academy of Sciences.