This is the first of a series of blogs tackling the thorny subject of profitability.
The key to a successful business is long term profitability. You may have huge sales volumes, but if you are selling at a loss, then your business will quickly fail.
But what is true profitability?
It is not just the value of the sale less the direct costs of that sale - for example in manufacturing, you can see a gross profit figure which is calculated by taking the sale, less the costs of the raw materials making up the end product you are selling,
There are also labour costs associated with "converting" those raw materials into the finished product and adding that extra value.
In addition there are the overheads of where that product is manufactured - such as the energy used to manufacture the product - these are variable and are determined by the volumes of product manufactured.
There are also fixed overheads which include the rent of the property etc which do not change whatever the volume of product is made.
Then you have the administration costs
The distribution costs
The capital costs (of any equipment used to manufacture)
Any discounts offered to customers
The cost of offering some form of credit to customers (your 30 day / 60 day terms)
All of these costs need to be taken into consideration when looking at a business's profitability. "That's nothing new" I hear you cry! - "of course we need to consider all of these costs.... That's what my P&L shows me!"
In the good times, you can get away with a summarised view of profitability, which is effectively that which is shown in your statutory accounts, but when you start to see margin erosion, what do you focus your efforts on?
Usually you will find this big black box which are your accounts, many customers, products, etc but how do you know which are profit makers and which are draining away your profit?
The time to act to get a better handle on your profitability is when your business is in a strong place - don't wait for when you start to get pressure from your investors / banks to improve those margins.
More traditionally, business would look at reducing overheads - "slice off 5% of costs across the board", "reduce headcount at head office by 500, because they can't be adding any real value to our business" are the sorts of themes which are often repeated and heard over and over again in business situations where they are going through a sticky patch and come up with a knee jerk reaction.
However - the true culprits can often be products which are expensive to make and / or distribute, and customers that have a high cost to serve.
These can often be customers which have been with the business for a long time and products which are old favourites - each of which would be regarded with some sentimentality and the "gut feel" that they have "always been good for our business" - often needing to be looked at in a more scientific manner.
How to change the behaviours?
This is where the analysis of your profitability becomes very important.You need to consider what level of analysis is appropriate for your business, the complexity of that analysis and the time and effort spent to produce the analysis v's the benefits which will be forthcoming.
There also needs to be a clear direction that although the analysis is not 100% accurate, it is accurate enough to enable decisions to be made which are balanced and enlightened.
It is really important not to get bogged down in the detail, but be able to select a correct level of analysis, otherwise you will find yourselves spending more time analysing, rather than running your business.
Firstly you should look at what granularity of data is being captured via your sales process. You may find in a manufacturing business using SAP Product Costing, that you are capturing both the sale and direct cost of the product at product level, and also at customer level, but any other direct costs such as discounts etc are held just at customer level.
Then you have the other overheads - Can any of these be assigned directly to certain products or customers? Is there a fair way of allocating some of them to certain segments / brands?
You may find that a certain team of people only work with one brand - in that case, it is reasonable to assign their costs - salaries, office costs, expenses directly to that brand. However this should be done with caution, because if there are other brands in your portfolio that do not have similar costs assigned to them you will get an unfair view of their profitability.
Looking at a service based business, the cost to serve customers becomes more important, and how to allocate resources which are used cross customer / cross product/ brand in an equitable fashion can often be a real headache.
It is often wise to start with looking at where the largest percentage of your costs are - so in manufacturing this could be your cost of raw materials, or your cost of conversion such as labour costs or the cost of that new bit of equipment (both depreciation and maintenance).
Distribution / haulage costs can often be high and overlooked. If you are working in a service based business, it is likely that your people costs are one of the biggest areas of expense, in addition to perhaps property costs.
Once you have been able to identify an equitable way to split these major costs across your main segments/brands/customer channels, you are on your way to starting to get to grips with where your business makes its profits, and whereabouts your profits are eroded.
How have others overcome these challenges?
I have worked with SAP products for well over 15 years now, initially as a Financial Controller, trying to interpret the results I was given from FI/CO modules through to a consulting role, all focussed on improving the transparency of financial reporting to support better business decision making.
Within the SAP portfolio of applications, there are numerous solutions available to enable this type of profitability analysis and reporting, ranging from the modules in SAP ERP such as Profit Centre accounting and CO-PA through to the Enterprise Performance Management suite including the Profitability and Cost Management application.
Each business has its own challenges and is at a different stage along the road of understanding its profitability. It is important to choose the right combination of the applications available to you, to get the right solution for your business and ensure it is scalable and future proofed, so that as your businesses profitability analyses requirements become more astute, your IT solutions keep up with minimal re-work.
I personally do not think that a single SAP application will provide a complete profitability reporting and analysis solution, but I do think a clever combination of them will give a good level of transparency to allow educated business decisions to be made.
Watch out for my next blogs which will analyse the various solutions available for use by SAP centric organisations at varying levels of complexity and maturity to try to guide you through the options.