Do you know where you are making money?

Do you know the profit of your company in a timely, accurate manner? If not, consider enhancing the systems and controls that you are using.

Do you know which product/service is most profitable? If not, identify the revenues and costs associated with each product/service.

Do you know how the fixed costs, a significant portion of sales, relate to your product/service? If not, conduct an activity-based costing study to define product/customer profitability.

Do all your team members understand how they contribute to profitability? If not, develop and communicate critical success factors or a balanced scorecard.

How a business answers these questions evolves as it grows.

Initially, a reporting system must provide profitability reports timely and accurately. When the business grows to selling several products or services, a basic formula is generated to determine product/service profitability. As fixed costs grow to a significant percentage of revenue, additional costing is completed to accurately determine product profitability. This costing also facilitates the calculation of the profit generated by each customer.

Finally, the critical success factors to measure profitability and strategic success are identified and communicated throughout the company.

Timely, Accurate Information

The first step in identifying profitability is to insure timely, accurate financial information is available. Without accurate information, a great deal of anxiety is generated. Gary Green, founder of Performax Products, Inc. recently sold his business but remembers, during the period of rapid growth, the anxiety and frustration with a reporting system with a margin of error of plus or minus 20% of net income. Accurate systems along with checks and balances need to be in place, particularly, for inventory, cash, accounts receivable, and accounts payable.

Scott Schwefel, CEO of Benchmark Computer Learning, the states largest technology training center with $8 million in revenues, requires that profitability be determined within ten days of the previous month end. A company meeting is held each month to review the profit and loss statement as a report card. Team members have developed a good understanding of the business from the open book management of Benchmark. All members of the team are business people that can impact profitability and then are rewarded through profit sharing.

Ad Hoc Product Profitability

Tom Hoblit, a turnaround specialist, suggests one of the key areas where he sees businesses fail is in construction of their financial reporting system. He suggests that the system must identify the revenues related to each segment of the business and the costs related to service it.

Most companies begin calculating the product/service profitability by identifying costs directly associated with making or providing the product/service and then applying a portion of the fixed costs. In Performaxs case, this meant calculating the cost of the bill of materials associated with each model of its drum sanders. An overhead burden was then applied to define product profitability.

Similarly, Abraham Technical Services, a $14 million total bar coding solutions company, determines a weekly break-even point. Standard pricing with minimums is established; then, standard margins by product group are projected. With an understanding of monthly fixed costs, break-evens are determined. Steve Schmidt, CEO, is able to monitor profitability on a daily basis by comparing actual sales to product group sales goals. These figures are also posted on the network so that all team members can monitor progress.

Product/Customer Profitability

As a company grows, the growth in fixed costs must be allocated more precisely to the products/services sold to accurately measure profitability. While there are many ways to perform costing, activity-based costing lends its results most directly to determining where value is added to the customer and thus, increased profitability.

Activity-based costing views a business as a network of activities that exist to meet customer needs. The activities performed to deliver a product or service are first identified and then valued.

The costing process identifies cost pools and cost sources, defines activities and links cost to activities and activities to products and/or customers. Cost pools are defined as costs that possess similar characteristics: for example, the cost of salaries and benefits behave similarly and create a cost pool. Cost sources are the functional units that incur costs such as operations, sales, marketing and administration. Activities are actions performed by a cost source to provide a service or to produce outputs. For example, an activity within the sales function may be taking an order.

Tracing factors link costs to activities and activities to products or customers. When tracing the cost of rent to an activity, the tracing factor may be the amount of square footage required to perform the activity. Similarly, the amount of time required to take an order may be a tracing factor for this activity to a particular product.

The goals of activity-based management are

• To measure the costs associated with an activity,
• Analyze the value contributed by the activity in relation to the costs of an activity,
• Identify opportunities for continuous improvement.

Results from an activity-based costing study may impact pricing decisions and identify opportunities to reduce costs. And defining product and customer profitability allows companies to make smarter decisions about allocating resources. For example, if you know which customers contribute the greatest profitability, the characteristics of these customers can be defined and allow the sales force to target similar customers.

Critical Success Factors

A good management reporting system provides details on critical success factors. Critical success factors track strategic success and profitability by translating strategy into key measures. Financial measures typically indicate success after the fact. These measures are called lagging indicators. Many non-financial measures predict strategic success and profitability in time to facilitate proactive management. These measures are called leading indicators.

As part of open book management, Benchmark Computer Learning posts results. Graphs that compare actual revenue and profit performance compared to plan are displayed. Key indicators that predict profitability are also tracked. For example, classroom utilization is monitored as a leading indicator.

Within each functional area, additional indicators may support the company-wide measures. For example, Donna Green, retired Vice President Performax Products, Inc., found that a useful measure was cost per lead. Each ad placed was coded with a department. Through tracking leads by department and comparing the number of leads to the cost of placing that ad, the cost per lead was calculated.

This information not only identified which publications worked most effectively but also provided a tool to negotiate space costs with the publication.

In 2000, approximately 40% of the Fortune 500 are expected to implement a new tool--the balanced scorecard. The purpose of the balanced scorecard is to translate strategy into a measurable tool. This tool goes beyond just financial measures to measure indicators of strategic success in the customer perspective, internal business perspective, and learning and growth perspective. The customer perspective measures product attributes, customer service and image. Examples of customer perspective measures are customer response time, on-time delivery and market share. The internal business perspective measures innovation, customer management, operational excellence and regulatory compliance. Headcount is an internal business perspective measure. Finally, the learning and growth perspective measures the capacity for growth. An example of the learning and growth measure may be revenue per employee.

Growth perspective measures demonstrate how the balanced scorecard includes long-term success rather than just measuring the immediate impact to short-term profitability.

Profitability and performance measurement information facilitates proactive changes in strategy to achieve desired goals. This information is used to:

• Support pricing decisions
  
• Justify marketing expenditures
  
• Analyze product mix changes
  
• Review distribution channels
  
• Identify process improvement and cost reductions
  
• Define resource allocations

Armed with a strong management reporting system, a growing business is equipped not only to know where it is making money -- but also how to make more.