Profitability expert and Senior Lecturer at MIT, Jonathan L. S. Byrnes, was kind enough to take the time to answer a few questions about his visionary and revolutionary book Islands of Profit in a Sea of Red Ink: Why 40 Percent of Your Business Is Unprofitable and How to Fix It.
Jonathan L. S. Byrnes makes the startling statement that 40 percent of any business is unprofitable by any measure. He points out that managers are not only not examining or taking action to correct the problem; but are very often not even aware of its existence.
Thanks to Jonathan L. S. Byrnes for his time, and for his very comprehensive and informative responses to the questions. They are greatly appreciated.
What was the background to writing this book Islands of Profit in a Sea of Red Ink: Why 40 Percent of Your Business Is Unprofitable and How to Fix It?
Jonathan L. S. Byrnes: I have done research and consulting on profitability for over 20 years. I first saw the amazing pattern of profitability – islands of profit in a sea of red ink – when I worked with a leading laboratory supply company. Soon after, I saw it again with one of the leading telecom companies. In both companies, I found that I could make major improvements quickly and without the need for costly initiatives. Since that time, I have seen the same thing in over a dozen industries, including steel, healthcare, retail, manufacturing, high tech, and financial services.
Sean Silverthorne, editor of Harvard Business School’s Working Knowledge website and e-newsletter invited me to write a monthly column on profitability, and more recently I developed this knowledge and experience into Islands of Profit in a Sea of Red Ink .
You make the startling point in the book that 40% of a company is very unprofitable, and that 20% - 30% of the company is very profitable, while the rest of the organization is marginal at best. Why is this phenomenon occurring across so many companies?
Jonathan L. S. Byrnes: All of our management information and processes were developed in a prior business era. Our accounting categories are too broad to see which accounts and products are profitable and which aren’t – so people simply assume that more revenues equals more profits. Some revenues are very profitable, and a surprising portion produce big losses. In virtually all companies, no one is responsible for monitoring and managing the interaction of revenues and costs at the grass-roots level to maximize profits.
Is it possible to pull up the losing operations, boost the languishing mediocre departments to profitability or does something else need to be done?
Jonathan L. S. Byrnes: Yes, it is certainly possible to improve most of the losing operations. However, the first priority is to secure the profitable business before a competitor goes after it with a focused offering. The second priority is to get more business that fits the company’s operations. Only after that should a company focus on turning around the marginal business. As a last step, the company should reprice the business that will never make money.
Can companies duplicate or enhance the real profit generating power of the best performing departments across the entire company?
Jonathan L. S. Byrnes: Yes, companies can both duplicate and enhance the profit generating power of the best business. The key to the former is to identify high-potential under penetrated accounts and to focus sales and service resources on ramping them up. This will rapidly increase the company’s high-profit business. The key to enhancing already profitable business is to develop products and services that fit their unique needs. When a company concentrates on its high-profit core of business, and devotes appropriate resources to the effort, it can easily lock in the business and even increase its profitability.
The problem is that most managers try to maximize revenues, assuming that this will maximize profits. This is a big mistake. They wind up with average products and services aimed at the average customer, and this gives them only average profitability – profits much lower than they might otherwise be, and an amazingly large amount of embedded unprofitability.
Jonathan L. S. Byrnes (photo left)
Why is no one thinking in terms of profitability in these companies?
Jonathan L. S. Byrnes: Most managers make three big mistakes:
(1) assuming that more revenues means more profits
(2) failing to focus attention and resources on securing and growing the business that produces high sustained profitability – this makes a company vulnerable to focused competitors and reduces reported profits.
(3) failing to put anyone in charge of maximizing account and product profitability at the grassroots level (in contrast with putting lots of people in charge of managing budgets).
Are the management concepts in current use perhaps out of date in the modern economy?
Absolutely. In the prior “Age of Mass Markets,” companies sought the economies of scale of mass production, coupled with mass distribution using arm’s length customer relationships. In that era, more revenues really did mean lower costs and more profits.
In today’s “Age of Precision Markets,” companies form different relationships with different sets of customers, each with different costs and profits. Yet, virtually all of our management information and processes were developed in the prior era, when all revenues really were equally desirable. This is the underlying reason why almost every company has so much embedded unprofitability and why so many managers fail to see and build their sustainably profitable core of business.
Many companies believe that revenues are good and need boosting; and that costs are bad and are something to cut in every way possible. Why is this a myth that needs challenging?
Jonathan L. S. Byrnes: Some revenues are very profitable, and some are very unprofitable. When managers use “profit mapping,” which I describe in my book, to look carefully at their companies’ net profitability, they see that 20-30% percent is profitable, 30-40% percent unprofitable, and the remainder marginal. This is true of virtually any company.
By focusing on average, or aggregate, profitability, managers lose this essential fact, along with the opportunity to quickly increase profitability at very little cost using sharply targeted measures. Because most sales compensation systems are based simply on revenues – and not all sales dollars are equally profitable (many are not profitable at all) - most companies are doomed to carry significant embedded unprofitability.
If all revenues are viewed as equally desirable, it follows that all costs are uniformly bad. Thus, most cost reduction programs are broad and across the board. This is a very big problem in a slow economy, when the instinct is to cut all costs in sight. In fact, the very profitable portion of your business can and should support the extra expenditures needed to lock in and grow that segment of your business. But this is usually precluded because the unprofitable business absorbs unwarranted resources.
Standard customer service advice is to treat all customers as being equal. Why is this the wrong approach?
Jonathan L. S. Byrnes: If a company tries to give all its customers the same service, it will wind up giving very profitable customers too little service, while unprofitable customers get too much service. Moreover, if the best customers are more capable at critical supply chain functions like forecasting, or have a higher-volume demand, or a steadily order pattern (all usually true), their cost to serve will be much lower than the average customer. If so, than the best customers will be underserved and overcharged. And this is usually the case.
The way to solve this problem is to use “service differentiation.” This means that the company makes different service promises (like order cycle time) to different customers, but always keeps its promises. The true definition of service level is the percent of time a supplier keeps its promises, not the nature of the promises themselves. If a customer wants faster service, it can sign a long-term cooperative contract.
Why is it not enough that everyone in the company does his or her job well to achieve profitability?
Jonathan L. S. Byrnes: This is a very good question. In the “Age of Mass Markets,” companies were in a homogeneous environment with arm’s length relationships. In this context, a company could set in place the activities of its functional departments (Sales, Operations, etc.), and the company’s success relied on everyone doing his or her job, without scrambling the other departments. A centralized, “smokestack” organization was indeed the most appropriate one.
Today, companies form a variety of relationships with their customers, and nearly all require close interdepartmental coordination for success. This applies to account selection, relationship selection, account development, and account management. In fact, today the best way to lock in a key customer is to develop a highly-integrated supply chain with the customer. This will reduce costs enormously for both companies, and drive sales increases of over 35%, even in highly-penetrated accounts. At the same time, the best way to increase supply chain productivity is to select the accounts and customer relationships that fit a company’s supply chain’s capabilities. Service differentiation is the key to this.
In this world, business success depends on everyone coordinating closely with his or her counterpart managers – all constantly changing what they are doing to accommodate the others so the company gets more and more profitable.
Many companies, top management, and their employees are resistant to change. How can company culture be changed to thinking in terms of profit?
Jonathan L. S. Byrnes: Top management must put in place four building blocks in order to lead a profitability transformation:
(1) the right information – granular (specific products in specific customers) not aggregated
(2) the right priorities – first, secure and grow the profitable business, then improve the marginal business, then reprice the money-losers
(3) the right processes – mostly coordinating sales, marketing and operations to get things right
(4) the right compensation, especially for sales – matching compensation to real profitability not just revenues.
However, the precondition for success is that everyone has to manage at the right level. Vice presidents should spend most of their time positioning the company for the next 3-5 years – since that’s the time it takes to develop major new initiatives. Directors (department heads) should spend half their time coordinating with each other to manage the company’s profitability, and the other half directing the managers who report to them. Managers should run the day-to-day company. Instead, in many companies, everyone focuses primarily on the company’s day-to-day performance.
What is the first step a company should take toward thinking more in terms of real profitability?
Jonathan L. S. Byrnes: A small team of managers can analyze the profitability of a multi-billion dollar company at a very granular level in several weeks using standard desktop tools. This is the first step. With this view, the management team can develop a highly targeted set of initiatives to secure and grow the best business, and to turn around the marginal business. Within a year, the company will experience a dramatic, sustainable increase in profitability.
What is next for Jonathan Byrnes?
Jonathan L. S. Byrnes: Good question. I’m very busy with my teaching and research at MIT, and with my consulting and Board of Director responsibilities. But I really enjoy writing. A number of managers have expressed interest in three areas:
(1) being effective (structuring, managing and leading change)
(2) account management
(3) small business growth and profitability.
I have done a lot of work in all three areas, and I’m intrigued by each. If your readers have any thoughts on this, I would love to hear from them – they can reach me at jlbyrnes@mit.edu.
Thank you for your time and interest. Jonathan
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My book review of Islands of Profit in a Sea of Red Ink: Why 40 Percent of Your Business Is Unprofitable and How to Fix It by Jonathan L. S. Byrnes.
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