by Robert D. Kugel, CFA |
9/2/2008 | Article ID: V08-32 | Article Type: VentanaView
Summary
After many years of achieving above-average profitability, corporations in the United States and elsewhere face an increasing cost/price squeeze (a phrase that was common in the stagflation-ridden 1970s). In response, they need to find ways to manage profitability more effectively. This is a cornerstone of financial performance management, and Ventana Research thinks that CFOs should drive initiatives that will enhance the bottom line. To do that, however, they will have to go beyond traditional “bean counter” approaches. Today, in addition to uncovering and eliminating unnecessary costs, profitability management involves optimizing (not simply maximizing) revenue. Cost-cutting is something that finance organizations are reasonably good at, but they rarely view revenue optimization as their mandate. Ventana Research asserts that finance organizations must lead the charge to enable operating units to fatten margins because these optimization initiatives typically cut across business units and because senior finance executives can bring to the process a corporate-wide view. Revenue optimization is an area CFOs must focus on now, rather than waiting until things settle down, because investments in processes and systems are likely to pay off continuously – in bad times and in good.
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Companies in industries that have benefited from increases in commodity prices and robust demand may be thriving, but the rest are feeling the impact of higher costs and a slowing world economy. The sharp rise in prices over the past year and the likelihood that these increases will reverberate in other costs over the next year or two are putting pressure on profit margins. Traditionally, companies have responded to narrowing margins by cutting costs, and certainly this is important. However, many companies also have the ability to do a more effective job of deciding how much to sell and at what price so as to optimize revenue. In tough economic times most CFOs are reluctant to invest in new initiatives, but we urge senior finance officers to take a leadership role now to implement a more intelligent approach to making these decisions. This not only should lead to stronger cash flow in the near term but also will pay off in higher profitability (and possibly larger market share) when the economy re-accelerates.
Revenue optimization is not the same as revenue maximization (although for companies in which fixed costs represent the bulk of expenses they are functionally equivalent). Revenue optimization can involve pricing optimization, production optimization, sales forecast optimization or some combination of them.
Pricing optimization derives from the concept of “price elasticity,” which reflects the relationship between changes in quantities demanded of a good or service and changes in its price. For various reasons, some buyers are more sensitive to price than others. For example, to take advantage of such attitudes, airlines and lodging companies began implementing “yield management” techniques in the 1980s to gain maximum advantage from bargain-hunting vacationers without losing potential revenue from business travelers, who typically are less flexible, and to better match the supply and demand of airline seats and hotel rooms at specific times and dates. Price optimization capabilities exist in most business and industrial markets (such as manufactured goods, chemicals and technology components and equipment) and a range of consumer goods and services (such as banking and consumer lending). While price optimization is not new, we believe that most companies outside of transportation and lodging have not adopted it at all or to the full extent they could or have not achieved proficiency in using it.
Production optimization is important whenever a company sells two or more products or services. Since resources (such as a piece of equipment, an entire plant or trained employees) are always limited, companies must choose what to make. To offer only high-margin products while needlessly leaving capacity idle is as counterproductive as generating market-leading revenue only on low-margin goods. Companies must find an optimal mix and set marketing plans and sales incentives accordingly.
Optimizing what a company makes can involve three types of initiatives. One is sales forecasting and demand planning (SFDP), a collaborative, cross-functional approach that brings together at a minimum production, distribution, sales, marketing and senior executives to continuously refine decisions on what to offer and how to offer it to whom. Another is business optimization planning, which requires those in operations to recognize that the financial implications of the production decisions they make go beyond simplistic linear programming (LP) models. LP models focus on trade-offs within “recipes”; rather, we advise considering business optimization planning issues – such as what plants build what product and when – within the context of business strategy and risk management given a current set of costs and prices. A third approach is advanced costing capabilities that give a company a clear picture of costs to support its SFDP and business optimization planning.
The key enabler for price optimization, sales forecasting and demand planning, and business optimization planning alike is software. Today, a majority of companies combine gut feelings with spreadsheets to arrive at answers – and usually each business silo does this for itself. Until recently this was often the only practical alternative, but that’s no longer so. In deciding which business initiatives to pursue in difficult times, we advise companies and their senior financial officers to support revenue optimization efforts, one aspect of which is investment in technology. Yet although software is a necessary component to driving any revenue optimization initiative, it cannot succeed without parallel actions to define (and continuously refine) the cross-functional processes that implement revenue optimization and the “people” issues that go with them (chiefly training, incentives and leadership).
Assessment
Finance organizations already play a role in managing profitability, mostly through broad budgetary targets and usually only by focusing on costs. While this works up to a point, Ventana Research advises CFOs who aspire to run a more effective finance organization to expand the mandate of their finance department to be an advocate for and a participant in ongoing revenue optimization efforts. The techniques and supporting technology are proven to work, but we find companies often miss opportunities to use them effectively because their initiatives are narrowly focused and parochial. Implementing revenue optimization ought to be a multiprong, multistage, multiyear effort with a senior-level focus. Each of the components (for example, price optimization and SFDP) can produce benefits by itself. But thinking of them as pieces of a strategic whole and implementing them as a coordinated effort are likely to enhance the benefits of each.
Related Research Notes:
Integrate Sales Forecasting and Demand Planning
Together, the Two Can Improve Performance
Make Sales Forecasting and Demand Planning More Effective
Addressing Accuracy, Collaboration and Strategic Alignment for Improvement
Managing Customer Profitability
A Strategic Initiative for Finance Executives
The Effective CFO
For finance leaders, efficiency isn’t enough any more
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