Sustainable Success: A Framework for Optimizing Profit

All management teams want to position their company to weather the ups and downs of a business cycle without compromising its ability to thrive. The key to that goal is optimizing profit targets. While all organizations generally apply some effort to profit optimization initiatives, I’ve found that when those attempts fall short, it’s because they lack a strong framework for establishing the right targets or a strategy for executing on their goals.

Establishing this kind of framework is all the more important when economic trends are gloomy. A potential recession can cast doubt on expected revenue growth and cash flows. Inflationary pressures push wages, material costs, and operating expenses upward, eroding profitability unless they’re swiftly countered with price increases or other offsetting levers. Higher interest rates tighten the screws further, negatively impacting return on invested capital, especially for businesses with unhedged floating-rate debt obligations.

That doesn’t mean it’s time to panic. Challenging times present an opportunity for leadership to head off financial distress by reviewing company processes, vendor agreements, product portfolios, pricing, and other factors to streamline operations and craft strategies that deliver optimal margins while enabling the business to achieve key objectives. Having resources allocated as efficiently as possible allows management to move quickly and confidently in the face of headwinds. And if a recession doesn’t materialize, or other trends improve, your company will be more advantageously positioned to capitalize on new growth investments.

In this article, I outline a four-step strategic process businesses can use to successfully define and implement profitability optimization initiatives in the face of steep inflation and high interest rates. I focus on EBITDA margins in order to eliminate the noncash impact of depreciation and amortization, which are less directly impacted by profitability initiatives.

Step 1: Define Optimal Profitability and Establish Targets

As Yogi Berra famously said, “You’ve got to be very careful if you don’t know where you are going because you might not get there.” Once you untangle this advice, it applies to all strategic planning. When dealing with profit optimization, it’s critical that management doesn’t engage in initiatives that deliver short-term improvements at the expense of long-term strategic objectives.

Frequently, I’ll see management teams set goals without knowing the true potential of their business. Traditionally, you’d analyze your historical data in order to estimate future profitability targets—however, that can shortchange your organization. In isolation, historical data can’t tell you everything about your business capabilities, especially as circumstances change, or whether your company’s previous performance is sustainable in the long term. If you only look at what you’ve done before, you could set a target that falls well short of—or worse, in excess of—what you can actually attain.

For example, a company’s management may see that the business averaged an EBITDA margin of 13% over the past three years. Partially due to external factors, margins have decreased to 9% this year. By establishing goals only on the basis of the historical data, management establishes the initiative of restoring EBITDA margins to 13%.

While this approach may work to sustain the business, allow you to achieve prior profitability levels, or even reach new levels of profitability, it doesn’t define the true potential for EBITDA margins. Opportunities to achieve 15% or 17% margins might exist, but the company will never reach them if its leaders don’t understand what’s possible. Over time, these percentage points will become worth millions of dollars to stakeholders. Let’s examine what you should do instead of relying solely on historical data.

Looking at the example below, we can see that the (creatively named) ABC Co.—a hypothetical HR and payroll software company—is currently enjoying an EBITDA margin of 15% with a historical five-year average of 13.5%. But ABC Co.’s leadership should not assume it can rest on its laurels.

By pulling individual company data for competitors and performing additional industry and market research, it’s possible to establish industry average EBITDA margins, as well as margins for similarly sized companies. This data is readily available for public companies; for private companies, you may only be able to obtain it through a paid service like D&B Hoovers, IBISWorld, or Pitchbook. If your business is having difficulty accessing this information or finding quality data, a good finance and strategy consultant will be able to help provide benchmarking data and to conduct a thorough analysis with actionable conclusions.

In the case of ABC Co., we’ll establish that its best-in-class EBITDA margins for its industry are in the 28% range, per IBISWorld research. At this point, ABC Co. can establish a few benchmarking scenarios for what its own optimal EBITDA margin could be—best in class, high performer, industry average, or comparable to an average similarly sized company. With this information in hand, management can then begin evaluating performance against these benchmarks to establish which one might be attainable.

Let’s assume ABC Co. management has established the following benchmarks to measure the company against, and set these associated targets. These benchmarks compare ABC Co.’s current performance against the best in class, high performers, industry average, and the average of companies of similar size. When conducting this exercise you should establish benchmarks with a similar logic.

ABC Co. management can see that it’s lagging behind the industry average in all margin metrics, though slightly outperforming the similarly sized companies’ average in gross margin and operating margin. As any management team should, ABC Co. leadership wants to deliver best-in-class performance. However, they feel that initially targeting best in class would be a daunting task for their employees and, not wanting to burn out their staff, decide to conduct the optimization process in iterative steps. After some discussion about the current state of the organization and the type of improvements that seem feasible based on current capabilities, they decide to target the high-performer EBITDA margins benchmark first.

Step 2: Identify Levers to Optimize Profitability

With benchmarks and targets established, management can move on to the next step of the strategy building process: identifying the operational levers that will lead to the targeted results, and then sanity-testing those targets.

Based on my experience with various clients, I know it can be tempting for leadership to focus on reducing operating expenses and implementing cost-out initiatives as a path to optimized profitability. Undoubtedly, operating costs and efficiency are significant factors in any overall strategy. However, management is doing a disservice to the organization if it overlooks the role revenue and gross margins can play in optimizing profit, as there may be ample opportunity to improve the product portfolio, pricing strategy, or cost of sales. These improvements can have a significant impact on EBITDA margins.

Regarding the income statement, I like to take a top-down approach to identifying operating levers so that revenue is the first item under review. The guiding questions during this stage of the process should be:

• What revenue factors contribute most significantly to EBITDA margins?
• Which of these factors does management have the most control over?
• Which of these factors can help management differentiate the business and establish a competitive advantage?

While the individual answers differ for all organizations, the most significant factors typically come from the following areas:

Product offerings: Evaluating product offerings can reveal opportunities to improve gross profit margins, which will flow through to EBITDA margins. Important metrics to consider include product mix, product quality, unit pricing, return rates, product adoption, and cross-selling or upselling success.

Sales operations: These metrics may uncover opportunities to improve the sales process, as measured by units sold, higher-margin units sold, reduced sales cycle times, and higher win rates for closed deals.

Customer satisfaction: Often overlooked, customer satisfaction doesn’t show up directly in the income statement—though net promoter scores, customer reviews, customer churn, and the average annual customer service contacts per customer are good indicators. However, customer satisfaction is critical to maximizing profit: Having highly satisfied customers results in lower levels of churn and returns, more frequent repeat purchases, and positive word-of-mouth marketing, which reduces customer acquisition costs, among other benefits.

Operating efficiency: This is the primary focus of most profit optimization exercises, but it should never be the only one. There’s always an opportunity to become more efficient and improve operating costs. Example metrics to evaluate include operating expense ratios, employee wages as a percentage of revenue, revenue per dollar of wages, and return on ad spend. Different industries will have many improvement opportunities. For example, manufacturing companies can examine throughput, machine downtimes, cycle times, and utilization, while financial services companies can review loan processing times, fraud detection, and customer churn. These areas of focus provide an all-encompassing evaluation of organizational performance and the factors that influence operating margins.

After performing internal and external benchmarking, ABC Co. produced the following analysis, detailing some of the drivers of EBITDA margin performance. We can see that internal, competitor, and industry performance all play a role in the evaluation.

As you can see, ABC Co. has uncovered valuable insights that will help inform its margin expansion strategy going forward. Here are the key action items resulting from this analysis:

• Improve communication of product value, as indicated by low percentage of customers purchasing subscriptions after free trial.
• Improve pricing strategy, as indicated by competitor pricing and low revenue per dollar of wages metric.
• Improve sales training and processes, as indicated by increasing sales cycles and stagnant average deal values that will negatively impact margins.
• Improve customer experience and satisfaction, as indicated by high rate of customer churn and poor customer sentiment shared in reviews and feedback.
• Improve organizational structure, commission plans, and other forms of compensation, and workplace culture, as indicated by low revenue per dollar of wages and high employee turnover.

Step 3: Sensitize and Prioritize Margin Improvement Initiatives

Once the biggest areas of opportunity have been identified, the next step is to discover, via a sensitivity analysis, which of these presents the most risk to EBITDA margins, and which offers the most potential improvement. This analysis allows management to start developing a plan to attack the deficiencies and expand margins. While ideally the business would focus on all areas of improvement simultaneously, in reality that may not be possible. Prioritizing the initiatives is essential to allocating resources to the most potent activities possible.

During this step, consider the following factors for each improvement opportunity:

• The degree of control management has over the opportunity
• The time it will take to make a change that has a significant impact on margins
• What it will realistically take to achieve the maximum potential improvement, assuming the most likely scenario
• How significantly each metric impacts margins

In my experience, the best way to approach this task is with a dynamic operating model in Excel that incorporates the key drivers of performance as independent variables that feed the rest of the model. While building an operating model is beyond the scope of this article, I’ll note that treating important operating levers as independent variables allows management to measure the impact of each variable in isolation, thus establishing its sensitivity to EBITDA margins and revealing the most important initiatives.

Continuing with our example: With the operating levers (independent variables) selected and the model completed, ABC Co. management calculated the specific sensitivities in the table below. The sensitivity calculation measures the percentage change in EBITDA margin for each 1% improvement in each of the chosen operating levers. Historical data and the correlation between individual operating levers and EBITDA margin can provide additional context.

As we can see, increasing the percentage of customers who subscribe to the company’s premium software offering increases the EBITDA margin more than any other lever. A 1% increase in sales mix results in a 0.5% increase in EBITDA margin, while increasing customer growth by 1% or decreasing customer acquisition costs by 1% results in only a 0.1% increase in EBITDA margin.

With sensitivities established, the next task is to determine the maximum expected improvement for each of these initiatives. Keep in mind the considerations mentioned earlier: the degree of control and the timeline for implementation. For the sake of simplicity, we’ll assume similar timelines for all potential initiatives, and the likelihood that improvements in one area will help other areas, compounding the effect on margins. (For example, decreased customer churn implies greater customer satisfaction, which can then contribute to reduced customer acquisition costs and lead to increased customer growth.)

Taking revenue per dollar of wages as an example, we can see that a 1% improvement results in a 0.4% margin boost. Some options to increase this metric include:

• Raising subscription prices for new customers while grandfathering in old customers to increase revenue.
• Improving the mix of premium subscription sales to increase revenue.
• Revising the commission structure to align sales incentives with strategic objectives.
• Reducing employee turnover and its associated costs.

There are many other possibilities; the point is that conducting this exercise for each initiative allows management to apply an expected range of outcomes and prioritize its options. ABC Co. produced the following output after establishing the best-case, base-case, and worst-case scenarios for each of its initiatives.

Assuming that these are new initiatives, ABC Co. leadership applied a subjective weight to each scenario, based on their judgment of its likelihood. If you have historical data from prior initiatives, that can also be used to inform the weights assigned to each case.

By calculating the weighted average of each scenario, ABC Co. management was able to come up with an expected EBITDA margin improvement for each initiative it identified. Since we’ve decided that for simplicity’s sake, time and degree of control are nonfactors in this example, the initiatives were then prioritized from the most impactful (premium sales mix) to least impactful (customer growth).

Step 4: Communicate and Implement

With the initiatives defined and prioritized, management now must communicate the plan of action to the rest of the organization and begin implementation. This requires as much care and planning as what has come before. The most well-defined plans will come to nothing without the right communication strategy, resources, and capabilities to support a successful outcome.

Here are the components to prioritize:

Project management hierarchy: A well-defined project hierarchy establishes accountability and creates a chain of communication and decision-making that helps improve efficiency. Clearly outlined responsibilities allow management to see where bottlenecks exist and act quickly to implement solutions.

Open and clear communication: This is a basic management principle and is widely applicable outside of profit optimization initiatives. Explaining the project’s strategy and expectations in an organized, transparent way helps to create a sense of ownership and buy-in from the employees charged with executing the plan. Additionally, promoting feedback and employee engagement can reveal new, innovative solutions that management may not have considered otherwise.

Formal progress reviews: Periodic reviews signal the importance of the initiative to employees. A lack of attention from management will lead to a lack of attention from employees, and result in stagnation and failure.

Resources and support: These initiatives are significant undertakings. It’s essential to be able to adapt the strategic plan and pivot quickly. New processes or tools may need to be developed or implemented. Management must be committed to providing whatever is needed for the team to achieve the desired margin expansion, or the effort will fail.

With transparency and sufficient resources, team members will be equipped with what they need to stay committed and motivated to deliver significant improvements to the organization’s overall performance. As we saw in the example above, the expected EBITDA margin improvement for ABC Co. adds up to 8.1%, assuming all initiatives are successful. That’s an additional $1.6M of EBITDA based on the company’s 2023 revenue. Even if it only achieves half the stated goals above, it adds 4% to the EBITDA margin.

For Best Results, Review Annually

By using the four-step approach outlined in this article, your organization will be able to successfully define a comprehensive strategy for optimizing profits. Best of all, this can be utilized as an iterative tool that supports several rounds of profit optimization initiatives until you’ve reached the targets you’re aiming for.

The benefit of this approach is that it identifies the most effective levers for improving profitability—which may extend well beyond simply reducing operating costs—enabling management to allocate resources appropriately and move quickly and confidently. Once the optimization process begins, the procedures outlined in the implementation stage help management quickly identify and address challenges.

I recommend integrating this profit optimization exercise into your organization’s annual planning process in order to keep priorities up to date. Should an economic downturn occur, your organization will be in the best position to withstand it. If there is no downturn, your organization will be primed to make smarter investments in growth initiatives. Either way, your company will be prepared for whatever the future holds.