There’s a difference between managing to profitability objectives and managing profitability. Standard planning software helps executives achieve profitability objectives by establishing top-level revenue targets and setting aggregated expense limitations. On the other hand, profitability management is designed to achieve consistently higher financial returns compared to this standard approach by performing profitability analysis at a more granular level to produce a clearer picture of economic costs and cost drivers. This is necessary because peer-reviewed research going back decades has shown that a significant percentage of customers are not profitable. Measuring profitability accurately means using economic costing methods, which provide a more precise approach than using accounting-based metrics. Having a more accurate measure of costs means you have more control and therefore able to manage pricing and operations in line with a company’s strategy, resources and market position. That doesn’t happen in most companies today. Our Office of Finance Benchmark Research found that only 34% of organizations manage customer profitability and just 30% manage product profitability.
As the first question suggests, one reason is that they think they’re already doing it in their planning and budgeting process. Another reason is that while individuals are responsible for achieving profit objectives, in most corporations, no one has specific responsibility for managing profitability across the board. The financial planning and analysis (FP&A) group in the finance department is the ideal candidate for this since it has the skills, training and understanding of the company. FP&A is also a neutral party focused on company-wide performance.
In a word, technology. Today’s software is designed to be a business application used by finance professionals, not a toolkit that requires IT skills. The ongoing digitization of business processes makes more data available and data management technology makes it possible to automate the constant acquisition of data needed in the process. Also, economic costing methods have evolved from the early approaches to activity-based costing. They are less complex to set up and use, which means organizations can achieve the desired results with much less effort. And today’s profitability management software isn’t tied to a specific costing methodology—it’s flexible enough to use any economic costing approach. Moreover, today’s hardware and software is better able to handle the volumes and complexity of data necessary for profitability management.
A profitability management application enables organizations to actively manage profitability from detailed product, customer and channel perspectives. It can regularly perform simulations and assess contingencies to allow executives and managers to define, devise and refine the most appropriate strategies and tactics to optimize the trade-off between profitability, market share, sustainability and other objectives. And it can do this at a level of detail that is impractical for spreadsheets or business planning and budgeting software.
ERP or core financial management software is designed to manage and record transactions. However, these systems are designed to record historical information and are not forward looking. And because these systems prioritize consistency and controls, they are not well suited to perform business analysis tasks, especially ones where flexibility is necessary to frequently adapt to changing business conditions. Also, using ERP or a core financial management system for allocations involves customization and configuration, which can be costly and introduces ongoing expense as the system is updated and maintained. The better approach is to use an analytical application dedicated to profitability management.
Having a more accurate picture of the real profitability of products, customers and channels enables executives and managers to understand the true economic profitability of those elements. This, in turn, allows leadership to define, devise and refine the most appropriate strategies and tactics to optimize the trade-off between profitability, market share and other objectives (within existing constraints). Beyond more informed pricing, knowledge of the true profitability of any combination of products customers and channels enables an organization to adjust offers, manage incentives and formulate bundles more intelligently. Avoided costs are pure operating profit. Beyond those benefits, a better understanding of costs is useful in setting defensible transfer prices, allocating IT spend more accurately, and deploying environmental and sustainability measures.