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The Three Tenets of Making Profits

The history and future of our business has been shaped by three profit guidelines. The specifics of these guidelines vary from company to company, but the general philosophy is applicable to most businesses.

Maintain a double-digit revenue growth rate . Revenue is the great enabler for performance improvement. We operate in a highly fragmented industry which provides ample market share improvement opportunities for our company. If we maintain outstanding field service, we are confident that we can continue to expand our customer base and maintain a high growth rate.
Manage job margins at current levels. A critical element of our companys program is to ensure that we do not dilute our business with ever less profitable work, or that we do not allow the profitability of current work to decline over time. We aggressively and consistently review all jobs to make sure that we are maintaining our overall margins at all times. Awareness of individual job margins provides the key impetus for a company to identify trouble spots and develop solutions to reach this goal.
Capitalize on the inherent operating leverage of the business. This final guideline focuses on managing the resource growth of selling, general and administrative expenses (SG&A) and support activities. The key is to make sure that these resources grow at a slower rate than sales. The earnings before interest and taxes (EBIT) margin of our company today is about 10 percent.

The margin on incremental sales growth is about 20 to 25 percent because of the need for less incremental SG&A and support costs for that sales growth. The combination of our base EBIT margin plus our incremental EBIT margin will lead to an increased total EBIT margin for the company over time. Until the new base margin is at the same level as the incremental margin, this margin growth will continue. As long as the total EBIT margin is growing, total profits are growing faster than the revenue growth rate.

Short Term Tactics: Possible but Not Consistent with Long-Run Success

Improving Profits in One Year

The most immediate profit improvement lever in practically any business is pricing. For a business with a 10 percent profit margin (a little better than average for the S&P 500), a 1 percent price increase will yield a 10 percent profit increase.

For a larger profit increase, say 50 percent, tactics are a bit different. While pricing is always a possibility, I would most likely focus on opportunities to capitalize on the inherent operating leverage of the business. Many costs of business (like corporate support costs, SG&A, occupancy costs, and other such expenses) do not increase in direct proportion to business growth. Therefore, the incremental profitability of sales growth is highersometimes much higherthan the companys base line profitability. Because of this operating leverage phenomenon , even fairly modest sales growth can lead to very rapid profit growth.

As an example, over the past five years , our company has increased revenue at an average annual rate of 14 percent. During the same time, our earnings have increased at an average annual growth rate of 65 percent! We have been able to achieve this growth organically, but acquisitions are another means to capitalize on operating leverage as well. However, with acquisitions, one needs to be careful not to inadvertently give back the potential synergies through too high a purchase price. Sometimes companies become so enamored with the potential cost savings associated with a business purchase and integration that they overlook or minimize the increased interest or capital costs associated with such a large investment. We have several examples in our industry where companies pursuing acquisition strategies defaulted on the increased debt incurred as a result.

However, much more important than short-term profit increases is the question, How can I build the long-term performance of the business? Pricing initiatives can be part of such a program, but over- reliance on a single area can cause problems in other aspects (such as lost volume) that can hurt overall performance. A successful business balances all aspects of its offering and supporting resources into a sustaining , profitable enterprise.

Reducing Expenses in One Year

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Again, I emphasize the caveat above that meeting a short-term goal, such as reducing a certain percentage of expenses in one year, without taking into consideration the long-term positioning of the business is inherently risky.

Second, it is generally helpful not to think in terms of absolute cost reductions but rather in terms of reducing the expense rate of a business compared to its activity level (such as SG&A costs as a percentage of sales). I could cut costs by 10 percent in a way that might reduce sales by that same amount or more and be much worse off. Absolute cost reduction is a misguided notion.

Nearly all cost reduction initiatives must focus on personnel. There may be some manufacturing businesses where this is not so, but I expect that personnel and personnel- related costs (benefits, payroll taxes, insurance) are by far the largest cost components . Furthermore, people drive the cost of everything else in the business (occupancy costs, supplies , travel). Consequently, a successful cost-reduction initiative needs to increase the sales per person of the business.

There are many potentially fertile areas related to personnel reduction. The best method encompasses a combination of the following: eliminate unproductive units, eliminate unproductive activities within all units, and eliminate the bottom 10 percent of employees performance-wise (high grading).

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The Three Tenets of Making Profits