Islands of Profit in a Sea of Red Ink Blog
This blog contains commentary on a variety of topics related to profit generation and profitability management. If you have comments or questions, please contact Jonathan directly at email@example.com.
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Current Posts and Previous Four Posts
November 21, 2013
Profit-based Segmentation, Omnichannel Retailing, and Same-day Deliveries
Recently a friend, who is editor of a leading business publication, sent me this note:
I wrote back the following:
Major changes are sweeping through retailing and distribution, upsetting traditional ways of operating. These changes bring huge new risks and enormous new opportunities. If managed well, a company can leapfrog its competitors, carving out a leading position for years to come. But if not managed thoughtfully, they can cause costs to explode, service to drag, and market position to falter in a surprisingly short period.
What are the key elements of success?
Over the past several months, I have worked with a major retailer that is a leader in its segment. This highly-successful company increased its already-strong profits by nearly 300% using profit-based segmentation in combination with a range of powerful enhanced services including omnichannel retailing and same-day deliveries.
The core to understanding how to craft a powerful, multi-dimensional, enhanced service strategy is profit-based segmentation, which is rooted in profit mapping. I’ve written about profit mapping in my book, Islands of Profit in a Sea of Red Ink, and in many of my blog posts. The underlying methodology is to create a full P&L on every transaction, or invoice line. You can aggregate these in a database, and unravel a company’s complex profitability picture along any dimension – customers, products, vendors, segments, sales reps, and others.
For example, we have developed a very powerful, sophisticated system that does big data profit analytics, including profit mapping; for more, please see: www.profitisle.com.
Profit maps are critical to developing and deploying new enhanced services like omnichannel retailing and same-day deliveries. They tell you where you are making money, and therefore where you can and should invest in enhancing customer service because you will get much more in return. They also tell you where you are losing money, and thus what parts of your business will become even more unprofitable if you continue to layer on more and more enhanced services.
Consider the following example, a disguised version of a very-successful company:
This is a very typical picture of a successful company’s profit landscape.
Islands of Profit. Only 9% of the customers are Islands of Profit – the company’s high-revenue, high-profit sweet spot – yet they bring in 47% of the revenues and a whopping 142% of the reported profits.
Your prime business objective is to secure and grow this segment of your business by building loyalty and providing terrific value, while attracting more customers who fit the profile. You should provide a full range of enhanced services to this segment because the payoff is very high, because it builds very strong competitive advantage, and because these services will enhance this key group’s loyalty.
Coral Reefs. On the other hand, Coral Reef customers – high-revenues but low-profit – represent 26% of the customers and 30% of the revenues – but only 6% of the reported profits.
These customers are large, but marginal or unprofitable. They don’t warrant provision of enhanced services unless you have a very well-managed program to convert them to Islands of Profit.
Note that most marketing analyses would treat both the Islands of Profit customers and the Coral Reef customers as the same because they focus on revenues, not profits. In fact, nearly all marketing analysts do not have the sophisticated analytics necessary to sort this out. In fact, because there are over three times as many Coral Reef customers as Islands of Profit customers, most services aimed at this combined group will be dissipated on unprofitable and marginal customers.
Minnows. These customers – low revenues and low profits – account for the majority of the company’s customer base, and 20% of the revenues – yet they actually eat away 50% of the profits made from other, primarily Islands of Profit, customers.
Minnow customers are small and unprofitable, yet in most companies they account for a majority of the business activity and a disproportionate amount of the costs. Simply offering enhanced services to all customers will mostly benefit the Minnow customers, with little return and wasted resources. Offering enhanced services only on larger purchases is similarly flawed because the purchase may well be unprofitable, and because an Island of Profit customer with an occasional small purchase surely warrants enhanced service in light of the overall relationship.
Your objective for this group is to minimize your cost exposure, unless you can convert them to Islands of Profit customers. For the most part, providing Minnow customers with enhanced services merely throws a lot of good money after bad.
It might be argued that some Coral Reef and Minnow customers might be enticed to become Islands of Profit, and thus should receive enhanced services like same-day deliveries. Often, this becomes a strong marketing argument. The right way to handle this situation is to offer the service on a trial basis, and to monitor carefully whether the customer’s purchase pattern changes and the customer actually becomes an Island of Profit.
Palm Trees. This company has only a few Palm Tree customers – low revenue but high-profit – with 3% of the customers generating 3% of the revenues and 3% of the profits. This is a small group, but important to the company’s prospects for future profitable growth.
In this way, profit-based segmentation enables a company to offer a powerful range of enhanced services, gathering huge benefits from its high-profit customers, while keeping its costs under control.
Powerful new services
What does this mean for the development and deployment of new enhanced customer services like omnichannel retailing and same-day deliveries?
It makes all the difference between success and failure.
Most companies simply assume that these enhanced services are new capabilities that they should offer to all their customers. This is a huge mistake, and it is rooted in a fundamental misunderstanding of customer service.
Customer service is correctly measured by how often you keep your promise to your customers. But you do not have to make the same promise to all customers. Here’s the dilemma: if you try to give the same fast or enhanced services to all your customers, your costs will explode – or your service will degrade across the board, unless you pour inordinate amounts of resources into customer service.
Better to define different levels of order cycle time or enhanced services for different groups of customers, with your Islands of Profit customers receiving the highest level of service, but with all customers consistently getting what they were promised. This way, you will be able to keep your service promises to all customers at a reasonable cost. For more on this, see my blog post on service differentiation, The Dilemma of Customer Service.
Thus, service differentiation is the key to linking profit-based segmentation to provision of enhanced services like omnichannel retailing and same-day deliveries. For example, think about omnichannel retailing, which many companies are considering in response to moves by Amazon and others.
Omnichannel retailing is a very powerful marketing approach that is now emerging. Many companies see this as necessary to stay competitive. Yet, it can be enormously expensive and unproductive if not constructed in a thoughtful way.
Profit-based segmentation is the key to getting it right.
Let’s return to the profit map. The omnichannel issue is analogous to the same-day deliveries issue, in a very fundamental sense. The question is whether a company simply assumes that its omnichannel resources (and same-day deliveries) should be spread across all customers and potential customers, or whether they should be concentrated where they provide the highest returns – the Islands of Profit customers.
Certainly, all-purpose websites are open to all potential and actual customers. However, really effective omnichannel retailing entails much more than that – enhanced services ranging from recognizing who is coming onto the website, to offering select customers custom views and online chat, to following up by email and phone, to enabling the customer to receive expedited shipping or priority on local store inventory.
The decision of how much to invest in enhanced services like omnichannel retailing and same-day deliveries should and must be determined by profit-based segmentation: it is not a question of whether to offer these services, but rather to whom to offer them. And, if the answer is effectively everyone, your best customers will wind up getting very thin gruel indeed.
As we saw before, Islands of Profit customers warrant the enhanced services that characterize really effective omnichannel retailing because they will generate ample profits that defray the cost and provide a strong return. If an Island of Profit customer occasionally consumes services but only has a small purchase, the overall value of the relationship still warrants great service.
On the other hand, in the absence of profit-based segmentation, companies most often fall back on simple segmentation based on overall customer revenues or order size. Both of these segmentation measures are fundamentally flawed, and will create major profit drains that result in the inability to build great services aimed at those who really count.
Offering full omnichannel service, and similarly offering same-day deliveries service, to all customers simply dissipates resources faster, and leads to even less for the Islands of Profit customers who generate the company’s core profitability.
The worst case
The worst case scenario is that a company offers omnichannel services, same-day deliveries, and other costly enhanced services to all customers, quickly runs short of resources, and winds up with a meager, uncompetitive offering.
The biggest danger here is that if a smarter competitor develops a service differentiation strategy rooted in profit-based segmentation, and offers really state-of-the-art services to its Islands of Profit customers – with satisfactory services to its other customers – the competitor will pick off the best Islands of Profit customers from the other firms in the business. This will leave the other firms with only the marginal and losing portions of their businesses.
The smarter company that rooted its strategy in profit-based segmentation will leapfrog into a leading position, while the less thoughtful companies will see their key sources of profitability dwindle away.
The lesson? The key to success in this new competitive world is to shape and focus your strategy using profit-based segmentation. You will sprint to an early competitive lead, and harvest the enormous first-mover advantages for years to come.
October 4, 2013
Online Interview with Jonathan Byrnes
Recently, I was interviewed by Margaret Reynolds for Breakthrough Masters. The interview, on accelerating profitable growth, is now available on the web.
Here is the link:
I hope you find it helpful.
October 4, 2013
How to Double Your Market Share While Countering a Price War
Several weeks ago, I wrote a blog, “How to Win a Price War.” A number of readers sent me notes, including my former Harvard/MIT executive student, Tenglum Low. Tenglum was a top executive of both a major Malaysian steel company and a major brewery, and he related his experience doubling his market share in the face of a price war by focusing on turbocharging his company’s value proposition.
Here is his story (slightly edited):
Your article on “How to win a Price War” is great reading, and a reminder to corporate leaders on how to enhance profitability and market share through value creation and value capturing.
Sun Tzu had often reminded generals and sovereigns that the objective of war is not simply killing the enemy, but instead it is ultimately a means to gain power and kingdoms. The best generals know that the real victory is to win a war without the need to fight any battles.
The most effective generals seek to win a kingdom without destroying its resources, so as to fund their next battle. Hence, in the world of competition, we should destroy the enemies without destroying the industry profitability. When we become the market leader, we can command a substantial portion of the industry profit pool.
I remember fighting the Malaysian steel war in the 1990s as a young Head of Commercial of Southern Steel. Within three years, we grew from 30% market share to 60% market share in domestic wire rod. Many strategic moves were played in the near duopoly market.
Today, I would like to narrate our moves in response to steep price discounts by the market leader at that time.
The steel products were near homogeneous in quality. But despite this, the slight differences of the products of the steel mills – if synchronized well with the production equipment of the customers – can make great differences in customer productivity. Hence, if any steel mill became the dominant supplier to the users, it could “re-synchronize” its products with the customers’ equipment, and thereby significantly enhance the customer’s productivity. Then, if the customer used the same drawing process with another supplier’s wire rod, the customer’s productivity would drop significantly – and these losses would be much greater than any price discount offered. This essentially locked in a relationship with very high switching costs.
With this knowledge in mind, we evaluated the customers through a new paradigm. We looked at the concept of “supply chain versus supply chain”, and how we could focus on growing carefully targeted customers in order to grow our sales.
The customers, at that time, could be segregated into six areas of downstream products. We decided that we could not be a supplier to all the customers in each segment because each of them wanted to become the leader in its respective downstream segment. Customer competition was extremely intense. We decided instead to pick a few leading players in each downstream segment and nurture them into market leaders. These customers needed to buy more than 70% of their steel requirement from us in order for us to “re-synchronize” our products with their production equipment, thus giving them the great benefits of higher productivity, and, once this transition was made, the 30% supplied by our competitors would have an inferior value proposition.
To enhance this mutually beneficial relationship and generate more sales, we supplied them with very competitive prices for their export requirement, which filled up their surplus capacity.
Meanwhile, our competitors offered price discounts to their customers in the nail segment to disrupt our dominance.
At that time, nail customers used 0.12 carbon killed steel as their raw material, priced at RM1200/metric ton. (Killed steel is a lower grade of steel, which has a lower drawability than rimmed steel.)
Our competitors offered our customers 0.08 carbon rimmed steel at RM1250/metric ton instead of the usual RM1300/metric ton, which was a big discount.
However, we understood the following issues:
- At RM1250/metric ton on wire rod produced from imported raw material, the competitors barely made profit (Malaysian steel mills could only produce killed steel, while rimmed steel is imported);
- The 0.08 carbon rimmed steel is good for drawability, but being much softer steel, it is not suitable for the whole range of nails.
Instead of responding by simply following this value-destroying price war, we shifted the basis for the competition by creating a new product of 0.10 carbon killed steel, and sold it to our customers at a price of RM1230/metric ton. This better met our customers’ needs at a lower cost, and our competitors could not follow us.
We made more profit from these products, and the customers also saved more cost!
Eventually, through our “supply chain versus supply chain”, most customers bought more than 90% of their raw material requirements from us.
The moral of the story: The best way to win a price war is not to have one – by turning it into a value war; you will take the best part of the market, while your price-oriented competitors will not know what happened to them.
Many thanks to Tenglum Low, a very thoughtful executive and a great friend - JB
September 17, 2013
September 19 Webcast - Secure and Grow Your Islands of Profit Customers
I will be presenting a live webcast, “Secure and Grow Your Islands of Profit Customers”, on Thursday, September 19 from 1-2 p.m. EDT, offered by Modern Distribution Management. There is no charge for this webcast.
Here is a link to register for this event:
You can also view the webcast at a later time by using this link:
http://www.mdm.com/events/ and select “Archives.”
I hope you find it helpful.
July 26, 2013
How to Win a Price War
Price war! How can you win without destroying your own profitability? Fire a bigger weapon? Outlast your competitors?
Any way you look at it, a price war is the ultimate in self-destructive, lose-lose behavior – but it is one of the most common of all management problems and concerns.
Paradoxically, not only is a price war devastating for you and your competitors, but it is very bad for your customers as well. When a customer forces its suppliers to focus on price competition, it loses the opportunity to work with its suppliers to increase its real long-term profits in two crucial ways: (1) by reducing the joint costs of doing business together, and (2) by helping the suppliers to find creative ways to turbocharge their customer value proposition.
In short, the real win strategy – for both customers and suppliers – is to turn the price war into a value war.
When confronted with aggressive competitor pricing, the instinct is to respond with a price cut.
After all, why lose the business? Even worse, if you lose those customers by failing to respond, you could be in danger of losing them permanently, sacrificing the lifetime value of the relationship. This concern pushes managers to respond even more aggressively, and before long the pricing discipline of the competing businesses collapses, and with it goes the company’s profitability.
What can a manager do?
The best tactical answer is to attack the hidden assumptions that frame the price war.
For example, if a competitor quotes an uneconomically low price, why not suggest to the customer that it demand a five-year contract. After all, the price certainly will rise back to former levels once the incumbent is out of the picture. This demand will force the attacker to back down because the losses would be too great over a multi-year period.
Another effective tactic is to rein in the instinct to respond where the attack takes place. In most price wars, the attacker aims at your most lucrative accounts and products – your Islands of Profit. By responding where you are attacked, you effectively do the most damage to yourself – and often the least damage to the attacker.
In fact, in most price wars, the attacker is funding the price war by maintaining a very lucrative, protected portion of its business – its Islands of Profit – as its core source of cash flow and profitability.
The answer? Strike back at the competitor’s source of cash flow.
A classic example comes from the airlines a few decades ago. Some carriers, like United and American had very lucrative east-west routes (e.g. NY-LA), while others, like Delta, had very lucrative north-south routes (e.g. NY-Miami).
When an east-west carrier tried to enter a north-south route with low prices, the incumbent’s most common response was to match the price reduction, thereby losing a huge amount of money in its lucrative north-south routes – routes in which the attacker had little to lose but much to gain.
Instead, the smart response was to strike back by entering the attacker’s prime east-west routes with low prices – attacking the source of cash flow that supported the price war. This very quickly ended the price war. (Remember that it is illegal in the US to actually conspire with a competitor to set prices.)
Preventing price wars
These tactics are effective in framing an effective response to a price war. But how do you actually prevent one?
I was asked this question a few weeks ago by a writer who was working on an article about distributor branch pricing.
She asked how much “wiggle room” branches have when it comes to differentiating themselves from the competition based on price, and whether there is an argument for price matching if a customer comes in demanding a cheaper price they may have received down the road.
The answer is that there is a progression of three increasingly effective ways to respond to a price war – match the price, lower the customer’s total cost, or increase your value footprint.
Price. The seemingly obvious, and instinctive, way to respond is to simply to match the competitor’s low price.
This is an invitation to lose your profitability for two reasons: (1) your competitor probably will up the ante with another price cut, setting off a vicious cycle, and (2) you are essentially training your customers to hammer you on price at every turn. After all, you’re showing them that you will fold under pressure.
The more effective counter-tactics mentioned earlier – shift the time frame or shift the locus of attack – are much more effective than simple price matching. But it is even more effective to proactively act to prevent a price war. You can do this in two ways: reducing total cost and turbocharging your customer value proposition.
Total cost. The second – and much more effective – way to respond is to systematically find ways to reduce the cost of doing business with your most important customers. By reducing costs for both your customers and for your own company, you can create real new value that will endure in the long run. Smart customers will strongly gravitate toward this process.
You can take measures to reduce your customer’s direct cost. I outline and discuss these profit levers in my book and in many of my blog posts. They range from operations cost reductions (e.g. flow-through supply chains) to product/category management (e.g. product rationalization).
Conversely, customers can create surprisingly big cost reductions for the supplier. For example, by helping the customer smooth its order pattern, you can reduce your supply chain costs, often by 25% or more. Better forecasting offers similar gains, as does a limited but well-aimed product substitution policy. These profit levers benefit both the supplier and the customer – by much more than a simple, temporary price cut.
Smart suppliers pass a big portion of their savings back to their customers in price reductions. Here the customers know that the price reduction is fully warranted by real savings, and therefore can endure over time.
Customer value. The third, and most effective, way to “win” a price war is to prevent it by waging and winning a customer value war. Yet all too many managers think of this last, if they consider it at all.
Think about the example of Baxter’s Stockless business that I have often cited in my book and blog. For example, see: Profit from Customer Operating Partnerships.
Several years ago, Baxter was stuck in a price war, with its products like IV solutions, viewed as commodities mostly bought on price by low-level hospital purchasing staff. Baxter mapped the joint hospital-Baxter supply chain, and discovered that it could enormously reduce both businesses’ costs by sending a supervisor into a major hospital to count the needed product, then picking orders into ward-specific totes, and delivering and putting the product away on the patient floor or clinic.
This was the forerunner of vendor-managed inventory, which many companies offer today. Incidentally, Cardinal ultimately bought this business from Baxter, and Cardinal’s ValueLink offering is still an extremely effective business run in many of the best major hospitals.
Stepping back, Baxter developed a way to permanently “win” the price wars that raged in its business by converting them into a one-firm race to lower the total cost of the joint supply chain, passing this saving to the hospitals. And this saving was so large that it dwarfed the pennies at stake in the price wars.
However, Baxter packed even more into this business initiative. In the prior period, before the Stockless/ValueLink was developed, the hospitals were reluctant to operate a large network of off-site clinics and surgical centers. Many top hospital managers did not have confidence that their materials management staff could handle the complex scatter-site network of critical products.
The new partnership with Baxter enabled the hospital executives to gain confidence that the newly created supply chain, managed by a supply chain expert like Baxter (now Cardinal), could support the evolving network of facilities. In short, Baxter created a fundamentally new value proposition for the hospitals – enabling them to radically change the way they operated to bring huge new value to their customers – the patients.
The progression was incredibly powerful: from price matching, to total cost reduction that competitors couldn’t match, to partnering with the hospitals to create a fundamentally new and much more effective value proposition for the patients, which again the competitors could not match.
Baxter did not just win the price war – it eliminated it.
Baxter won the customer value war.
A Lesson from GE
GE is a very insightful, innovative firm. GE managers are trained not just to compete effectively, but to relentlessly search for fundamentally new and better ways to do things – winning by changing the competitive game.
A prime example of this is the decision of the GE aircraft engine group to change its product offering. In the past, the company offered traditional but effective product centered on aircraft engines and spare parts.
However, insightful executives stepped back and reflected on what GE’s airline customers really wanted: not just engines and parts, but rather, hours of engines effectively powering their aircraft. After all, they were in the business of flying passengers.
In response, GE developed a fundamentally new offering: “power by the hour”. GE wisely combined its prior offerings – engines, parts, and related services – into one offering that directly addressed its customers’ needs. Much as Baxter did for the hospitals.
Not only did this new “power by the hour” offering meet the customer needs much better that any competitive offering, but importantly, it combined a package of products and services that no competitor could match.
GE redefined its market so it had virtually no effective competitors.
Baxter did the same. So did Southwest Airlines.
The key imperative is very clear: Once you have a lead, step on the gas – and the most effective way to do this is by turbocharging your customer value proposition.
Islands of Profit
Winning the customer value war is most often surprisingly easy because your competitors rarely think about it. All too often they focus on tactics like price optimization, rather than accelerating their customer value proposition.
This is especially critical for securing your Islands of Profit – your high-revenue high-profit business. These customers are most susceptible to a competitor incursion, yet these also are the customers that are most receptive to innovations that fundamentally reduce your joint cost structure and transform your customer value proposition.
Your Coral Reefs – your high-revenue low-profit customers – on the other hand, are usually the most price-sensitive. Yet, many can be converted into Islands of Profit if you develop a compelling value proposition.
The same goes for your Minnow customers – low-revenue low-profit – especially those that are someone else’s big customers and are just using you to discipline the competitor’s prices.
The Essential Question
The essential question is: Are you so busy with tactical issues like price wars that you “do not have the time or resources” to systematically and relentlessly build your customer value proposition? Especially for your Islands of Profit Customers?
Winning the customer value war is the only way to permanently prevent price wars and really secure your future.
May 20, 2013
May 23 Webcast - Accelerate Profitability through Transformative Customer Service
I will be presenting a live webcast, “Accelerate Profitability through Transformative Customer Service”, on Thursday, May 23 from 1-2 p.m. EDT, offered by Modern Distribution Management. There is no charge for this webcast.
Here is a link to register for this event:
You can also view the webcast at a later time by using this link:
http://www.mdm.com/events/ and select "Archives."
I hope you find it helpful.