The key to that goal is Optimising Profet targets. While all organizations generally apply some effort to profit optimization initiatives, we have 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, we 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. We 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.
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 our experience with various clients, we 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.
