9/24/2013 | Keely L. Croxton

Perhaps no other piece of information is as insightful for business success as margins - understanding where money is gained and lost in the course of business activity.  Armed with this information, managers throughout the organization can determine where and how to invest, and what to focus on to turn unprofitable business into profitable business.  For middle market companies, this is particularly salient as they figure out how to grow the business in a resource constrained environment.

Our survey results show that for middle market firms, doing business is becoming more complex.  The majority are delivering an expanding array of products to an increasing number and broader geography of customers.  As they say, if your business is unprofitable, you can't make it up on volume!  So it is becoming increasingly critical that companies grow their business profitably, and to do so you need to know from where your profits come.

The results on tool usage suggest, probably not surprisingly, that basic tools and metrics are being used by the majority of companies.  It is very common for companies to measure things like profit margin, operating margin, and cost per unit, and indeed these metrics are good places to start to gain an understanding of where you are making and losing money.  However, the tools that we believe are the most helpful are not as common.  Using cost-to-serve models, activity-based costing, and balanced scorecards are all very helpful in understanding where money is being spent and what the implications are on margins.  And as the results do show, those respondents using these tools regard them as very helpful.  We encourage managers to look into using these more sophisticated tools - we believe they will make a significant difference in how effectively they manage margins.

An interesting finding of the research is that firms that do not use these advanced tools do not miss them, suggesting that their use would lend little additional insight.  It is possible that respondents are not fully aware of the explanatory power of advanced tools.  In other words, they do not know what they don't know.  Findings from our focus group research (which preceded the survey research reported here) indicated that those firms using methods like cost-to-serve modeling and balanced scorecard, among other advanced methods, believed that their use served as a source of competitive advantage when rivals failed to employ similar methods.  The rival firms were more likely to engage in unwise pricing wars and employ tactics that challenged profitability and, ultimately, weakened their long-term competitiveness. 

In our opinion, one of the most useful metrics for managing margins is profitability by customer.  This can help guide decisions about what services to offer which customers and how to allocate resources to customer relationships.  According to the survey, 61% of respondents said they measured profitability by customer.  Based on our experience and informal surveying of managers, we found this number to be surprisingly high and suspect that some respondents were thinking about revenue rather than profitability when answering this question (our suspicion is further strengthened by the fact that only 14% of respondents reported using cost-to-serve models, which are closely tied to customer profitability reports). 

While knowing revenue by customer is helpful, your largest customers aren't always your most profitable, so focusing on revenue might not lead to the best decisions.  In our experience, very few companies are able to accurately capture customer profitability as measured by revenue minus avoidable costs.  Most companies either do not generate customer profitability reports at all, or if they do, they allocate fixed costs in a way that make the reports meaningless.  However, having a deep and accurate understanding of which customers drive profits (and of course which do not) can help managers across the firm allocate resources to grow the profitable business and either shrink the unprofitable, or work to turn the unprofitable customers into profitable ones.

While not all products, services, or customers will be profitable for your company all the time, it only makes sense to try to understand where you are making money and losing money in the business.  Operating in the dark and simply hoping to win more often than lose is no way to run a business.  This analysis shed light on those tools and methods that senior managers and executives deem essential for managing margins.  While we were struck by the wide disparity in responses to questions about methods employed and their usefulness, the focus groups and survey research confirm that margin maintenance remains among the most pressing challenges for middle market companies.  We encourage decision makers to critically assess the tools they employ.  Consider the ROI of current and prospective tools and allocate what time and effort they can afford to using the tools that sheds the most light on the health of the business, informing these decision makers of which products and services to provide and what price levels, with whom to conduct business - both customers and suppliers - and the terms of that business.  In sum, we encourage these decision makers to rely on their smarts and not on their luck.