Conventional methods of optimizing profits could lead your company to miss growth opportunities. This four-step approach will help your company make the most of its assets to increase its margins for years to come.
All management teams want to position their company to withstand the ups and downs of an economic cycle without compromising its ability to thrive. The key to this goal is to optimize profit goals. While all organizations generally apply efforts to profit optimization initiatives, I have found that when these attempts fail, it is because they do not have a solid framework to define the right objectives or a strategy to achieve their goals.
The establishment of this type of framework is all the more important when economic trends are gloomy. A possible recession could call into question the expected growth in revenues and cash flows. Inflationary pressures are pushing up wages, material costs and operating expenses, eroding profitability unless they are quickly countered by price increases or other compensatory levers. Higher interest rates tighten the screw even more, which negatively affects the return on invested capital, especially for companies with unhedged floating-rate debt securities.
This does not mean that it’s time to panic. Difficult times provide an opportunity for managers to avoid financial difficulties by reviewing company processes, supplier agreements, product portfolios, pricing and other factors to streamline operations and develop strategies that provide optimal margins while allowing the company to achieve its key objectives. Allocating resources in the most efficient way possible allows management to act quickly and confidently in the face of headwinds. And if a recession does not materialize or if other trends improve, your company will be in a more advantageous position to capitalize on new growth investments.
In this article, I describe a four-step strategic process that companies can use to successfully define and implement profitability optimization initiatives in the face of high inflation and high interest rates. I am focusing on EBITDA margins to eliminate the non-monetary impact of depreciation and amortization, which are less directly affected by profitability initiatives.
Define the Optimal Profitability and Set Goals
As Yogi Berra said, “You have to be very careful if you don’t know where you’re going, because you might not get there.”Once you unravel this advice, it applies to all strategic planning. When it comes to profit optimization, it is essential that management does not get involved in initiatives that bring short-term improvements to the detriment of long-term strategic objectives.
I will often see management teams setting goals for themselves without knowing the true potential of their company. Traditionally, you would analyze your historical data to estimate future profitability goals; however, this can negatively affect your organization. Taken in isolation, historical data cannot tell you everything about your company’s capabilities, especially when circumstances change, or if your company’s past performance is sustainable in the long term. If you just look at what you’ve done before, you might set a goal far below, or worse, above, what you can actually achieve.
For example, the management of a company may find that the company has achieved an average EBITDA margin of 13% over the last three years. Partly due to external factors, margins have decreased to 9% this year. By setting targets solely on the basis of historical data, management is setting up the initiative to reduce EBITDA margins to 13%.
Although this approach may work to maintain the company, allow it to reach previous levels of profitability or even reach new levels of profitability, it does not define the true potential of EBITDA margins. There may be opportunities to achieve margins of 15% or 17%, but the company will never achieve them if its managers do not understand what is possible. Over time, these percentage points will be worth thousand of buck to stakeholders. Let’s take a look at what you should do instead of relying only on historical data.
Looking at the example below, we can see that the company ABC (creatively named) Co.- a hypothetical HR and payroll software company-currently enjoys an EBITDA margin of 15% with a five-year historical average of 13.5%. But ABC Co.leaders should not assume that they can rest on their laurels.
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