This second conversation with former Thomson Corporation CEO Dick Harrington looks at why small businesses need to understand their product line profitability. When Harrington was CEO of Thomson Corporation, now Thomson Reuters, cash flow grew by 4x.
Tony Tjan (TT): This is one of those common sense, not commonly done things...but remind readers why it's so important to understand exactly where their profits come from?
Dick Harrington (DH): You need to understand exactly where you make your money because that means you understand your business model well, and that's going to let you make the best decisions for growth.
TT: Could you use Thomson as an example?
DH: At Thomson, we had a business model with high fixed cost and very low marginal costs, so once you covered that fixed cost, every additional dollar of revenue was highly profitable. At that point you have as much an "EBITDA model" as a "revenue model" - and that is a good day. Understanding that what we were about was fixed cost leverage combined with recurring revenue that ultimately created very strong cash flow growth, was key to our success.
In terms of determining exactly which businesses were doing this well and where we were really making our money, we did a portfolio break down of income by product lines. If one wasn't making money, we wanted to know why. Perhaps it was just a loss leader, driving some other product, but we could also be underpricing it. On the flip side, for the ones that were really making money you wanted to be careful to make the right on-going investments and not be overpricing them.
TT: How would a small business act on this kind of information?
DH: For small businesses, you should know the cost structure for top products and be able to know if you made money or not just by looking at the revenue for each every month.
TT: So, do you think that most people today know that?
DH: I don't, because most small businesses bundle all the products into one big ball. Very few people are looking at product line profitability.
TT: But isn't that because product line profitability is hellish to measure? Do you really need to measure every SKU's revenue and profit and work through allocating fixed costs?
DH: Not quite; you can categorize products. And if you're small, you can estimate and be approximately correct. For example, if one product is consuming all your customer support resources, you want to account for it. But for small changes in floor space usage, for example, you probably don't need to factor that in. Being approximately correct is good enough; you don't need to have perfect information to make the right decision.
TT: How about a concrete example of how a small shop could apply this lesson? If they allocate a lot of time to product X or Y, should they account for that?
DH: Break down operating income or EBITDA by product line, and allocate any fixed costs that are consumed in different degrees. So if 50% of the floor space is for one product line, charge that product line the appropriate cost. If one product is a few more square feet than another, though, don't worry about it.
TT: How frequently should a small business be doing this?
DH: If you have sophisticated systems, you want to look at this quarterly. If not, do this kind of report every four to six months in order to confirm your own thoughts about where profit it is.
TT: Why do you think small businesses have a hard time with this?
DH: Small businesses start with a good idea, but eventually the business gets more sophisticated. The entrepreneur then tries to focus on what he knows best. So the engineer looks at engineering costs, the sales guy at sales costs, etc. No one is looking at the operation holistically.
You need to continuously think and assess if you are getting the right profitability information, especially in the context of competitors.
TT: How can you get profitability data for competitors at the product line level?
DH: Well, if you are a small business, the best you may be able to do is price comparisons. And be smart about this. If you think you get business because you charge 10% less, but everyone else is still busy, then you're probably leaving 10 cents of every dollar on the table.
TT: How much do you prioritize the cost side over the revenue size?
DH: Looking at costs should be a continuous process, but it's not going to drive profitability. If you are in the early stages of a business, focus out demand generation - the revenue side -- and then focus on optimizing costs. The first priority for a small business is always, always, always to get customers. Never forget that.
This article first appeared on Harvard Business Publishing on April 3rd, 2009.
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