Friday, March 12, 2010

Where Will Your Next Profits Come From?

How does your company make its money? I’ll wager it’s not in the way that you think. Not entirely, at any rate.

I typed the term “profit formula” into Google the other day, and the first entry I got was entitled “Calculating Gross Profit Margin.”

That’s not really surprising, since most companies measure profits in terms of margins, whether gross or net. What could be more rational? After all, at its most basic level, a company’s profit formula has two parts — revenue and costs. Sell something for more than it cost you to make it and you turn a profit. How much higher revenue is than cost for each transaction is the margin. So it seems logical that focusing on margins is a good way to keep track of your profits.

And it is. But it’s also a good way to close your organization off to the possibility of making future profits.

To understand why, let me lay out what I believe is a more useful way to think of profits — a formulation I’ve broken out into four parts to make it easier to view profit generation strategically. In this framework, the factors you need to consider when determining how your company will turn a profit for a given offering are:

  • Revenue model (price x quantity)
  • Cost structure (direct costs, overhead, economies of scale and scope)
  • Margin model (how much each transaction must net to reach the desired profit level)
  • Resource velocity (how quickly resources are turned into offerings — leadtimes, throughput, inventory turns, asset utilization).

Companies that habitually use margins to judge how well their current model is working often make the mistake of using them to judge how feasible a new opportunity would be, too. That leads them to reject out of hand any new business that might involve lower margins.

But as you can see from this framework, your current company’s margin requirements are a function of many other factors: the price you’ve set, the quantities you sell, your fixed costs, your economies of scale or scope, the speed with which you can get paid. Change any of these factors and the margins required to turn a profit change as well.

Granted, changing fixed costs, overhead, or the way in which customers pay you is hard for incumbents. But the very fact that it’s hard to think about profit generation in other terms is what creates opportunities — if not for you, then for focused start-ups unencumbered with your fixed costs or your need to sell at a certain price to maintain margin.

Dell Computer, for example, became extraordinarily profitable not just because it found a lower-cost way to make personal computers than its competitors, but because it found a way to get its customers to pay for the computers before Dell had to make them — thus assuring that it made only the computers that would be sold. With that advantage, Dell could be profitable at far lower margins than Compaq or IBM could ever accept.

That’s why Dell’s model was not only effective but sustainable for so long. Its model was not only new, it fundamentally conflicted with the models of its competitors.

IBM, the wily business model innovator that it is recognized the threat that Dell’s lower margins represented and further understood that to compete it needed not to copy Dell but to reengineer its own profit formula, which it did by offering up a business model innovation of its own — focusing more on higher-margin services. But the transition was painful — involving the layoff of some 200,000 people. Referring to how traumatic the memory of this was in an interview over a decade later, CEO Sam Palmisano put it like this: “Over the course of several years, we wiped out the equivalent of a medium-sized northeastern city — say, Providence, Rhode Island.”

Executives focus intently on margins for a reason — they’re the first indicator of risks to the business. I won’t argue with that. But too great a focus on margins carries risks of its own. How vulnerable would your company be to a competitor that has thought up a novel way to turn a profit in your market? You won’t begin to be able to answer that question unless you understand your entire profit formula, not just its margin requirements, and ask yourself how it might otherwise work.

Mark W. Johnson is co-founder and partner of Innosight.

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The INNOBLOG covers all aspects of innovation, from strategy to execution, in thought-provoking and insightful posts. Innoblog is a group forum to which many Innosight team members contribute. Outside contributions are welcome too. The blog is edited by Evan I. Schwartz, who also edits Strategy & Innovation.

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