The ultimate business metric is profitability. Companies are valued on their profitability, or earnings. Most valuation formulas and rules of thumb focus on a price/earnings ratio or an enterprise value as a multiple of earnings Generally speaking, this is what business buyers and investors care about most. Since profitability is calculated as revenue minus expenses, business managers are constantly looking to increase revenues and decrease expenses.
When Is Profitability Is Not the Ultimate Goal?
In some cases, there may be a strategic reason to prioritize revenue over profitability. Perhaps market share and brand recognition are deemed more important in the early stages of a company, and this can be achieved by prioritizing revenue over profitability. This is not uncommon for startups from the local main street business to Amazon. Or perhaps logistics and supply concerns warrant more focus on securing materials. During a supply crisis, the priority may be to identify more suppliers or to accept increased costs just to ensure there will be products to sell.
How Can Revenue and Expense Initiatives Effect More than the Bottom Line?
Your specific levers to control revenue and expenses may include pricing and sourcing. Yet pricing and sourcing strategies may affect market share, product or service quality, or quality of earnings or have other unintended consequences. Therefore revenue and expense initiatives must take into consideration all of the consequences.
Is it Better to Focus on Revenue or Expenses?
Whether revenue initiatives or expense reduction initiatives deserve more attention depends on the return of time and money invested in these initiatives. Here’s the exciting part as you embark on this process of prioritization initiatives: 1) you’ll identify low hanging fruit and 2) you’ll find some prized initiatives that will have a dual benefit of increasing revenue and reducing costs.
Assess Your Business with a SWOT Analysis
Before prioritizing revenue or expense initiatives, you’ll need to understand your business. A SWOT analysis will help identify core competencies and differentiators that influence return on effort. The analysis is also a great exercise to uncover potential revenue and expense initiatives you may have missed otherwise.
Identify Low Hanging Fruit for Both Revenue and Expenses
Low hanging fruit means anything that can be accomplished quickly and cheaply to produce some benefit. While the impact may not be as great as other initiatives, inexpensive quick wins will have a good return and also serve as positive momentum for initiatives to come.
Identify Initiatives for Increasing Revenue
Here are some ways to think about increasing revenue. Are there any low hanging fruit? Of the more involved initiatives, which ones align best with existing competencies? Also consider the quality of earnings.
- Raise prices
- Sell to more customers
- Sell more volume to each customer
- Sell a greater number of different products or services
- Sell to more markets
- Acquire companies or product or service lines
Identify Initiatives for Reducing Expenses
Here are some ways to think about decreasing expenses. Filter each opportunity against your SWOT assessment to come up with a prioritized list. Arguably, there may be more low hanging fruit in the expense reduction bucket than the revenue generation bucket. Involve key stakeholders to ensure cost cutting does not create more problems than benefits. There will be some tough decisions that require group input.
- Automate
- Make versus Buy or vice versa
- Buy larger quantities of materials at a discount
- Shop for new suppliers or negotiate with current suppliers
- Increase labor efficiency
- Reduce CAC (customer acquisition cost) by optimizing marketing strategies or channels
- Reduce CAC with repeatable sales, ordering processes, or training
- Implement repeatable processes that reduce cycle time and minimize mistakes, returns and rework
- Find ways to lower interest or taxes
How to Have the Right Balance of Process and Flexibility
Be careful when a leader says “we are transitioning from process to progress” or some statement that treats this as a binary decision. It’s never either-or with process and flexibility, it’s a balance of the two. Even a startup needs processes, even if they adjust frequently. The concept of MVP (minimum viable product) is a process for startups or product launches within established companies. Keep these thoughts in mind when addressing process and flexibility in your revenue and expense initiatives.
- The “weight” of the process must fit the company and the stage that it is in.
- Be process-optimized, not process-heavy or process-light.
- Visionaries find roads. Leaders enable and support processes. Managers implement and optimize processes.
- Early stage companies or divisions need flexibility, but processes should still be considered at the appropriate “weight.”
- Later stage companies have more opportunities to drive efficiency with processes and automation, but still need room to adapt
Chain Initiatives Together to Increase Revenue and Lower Expenses
These initiatives start as either a revenue or expense initiative and lead to an immediate opportunity in the other bucket.
- Scale Initiative: Increased volume leads to increased revenue and lower costs
- Cost Containment Initiative: Cost reduction may enable lowering prices to increase overall revenue
These initiatives can address both the revenue and expense buckets simultaneously.
- Optimize Portfolio of Products, sales channels, markets
- Re-investment ROI – increase revenue or savings
Is There a Profit Plateau?
I’ve spoken to many business owners who told me they used to be bigger at one point. A common theme was that they found the maximum size they could operate comfortably without stretching their skills or accepting considerable risks. “Today I have 30 employees and everything runs smoothly. When we had 40 employees and more revenue, I wasn’t making any more money than I am now. It was a lot more hectic and I realized it wasn’t worth it.”
Most owners are happy to operate at their natural sweet spot, while some are motivated to break through but don’t know how. There are teams of consultants that help business owners solve the plateau problem. Often it involves hiring new skill sets to supplement and / or replace the owner. A lot depends on the owner’s willingness to loosen the reins and work with new decision makers. Owners often say “if I were twenty years younger, I would…” Realistic owners recognize that a breakthrough may require leadership that is younger/smarter/more experienced/more networked/etc.
What to Do When You Reach the Profit Plateau
Owners can do the following to anticipate and address the profit plateau:
- Identify the point of diminishing return where sales increase but profitability does not
- Attempt to understand the levers and skill sets required to grow past the profit plateau
- Determine if the expertise to break through the plateau, as well as the will power, exist in-house
- If not, then consider these options:
- Make an exit plan
- Relinquish partial ownership
- Recruit new leadership
- Acquire a direct competitor (may minimize need for significant new skill sets)
- Acquire a tangential company and merge new leadership skill sets
- Stay the course
Summary: Understand Overall Impacts and Optimize Incentives
Earlier we gave a few examples of how revenue and expense initiatives can affect more than the bottom line. Another way of saying this is that an immediate positive impact may result in a longer term negative impact. For example, a cheaper raw material saves money now, but may reduce revenue later if quality suffers.
Case-Study
In a fast-paced technical sales environment, sales executives were incentivized to sign contracts for construction projects. The projects might take weeks to get started and months to conclude. The sales compensation incentives focused on signed contracts. This rewarded certain sales executives who painted a rosy picture over those who set realistic expectations. There were many opportunities for buyers to cancel and they often did so if they felt they were misled or uninformed after doing more due diligence, speaking with competitors, or speaking with contractors. Eventually, the sales compensation structure incorporated more considerations that included cancellation rate, completeness of paperwork, etc. The new structure incorporated hidden costs to the company relating to re-work, inaccurate forecasts and brand reputation.