The surprising factors that influence business profitability
Full disclosure, right at the start, the title is not the real pitch of this article series. The aim of this series is to review some of the ways that operational managers and executives/shareholders can work together to increase profitability and not work in opposition to each other.
I was doing some work recently with a client on employee engagement with the purpose of improving workplace satisfaction as well as business performance. It’s a win:win. We have devised a way to measure employee engagement and track it over time and we wanted to relate that to business performance measures. The obvious measure would be profit, albeit not the only one. This is fine when measuring one company, but what about benchmarking with other companies from different sectors where business model variations lead to different profitability?
Which got me wondering, what are the underlying drivers of profit that can be compared across companies? The obvious drivers of profit such as number of customers, average transaction value and profit margins cannot be easily compared across sectors with different business models. Furthermore, it’s not easy to access that kind of data. What data would be accessible? This led me on voyage of discovery which led to well away from employee engagement into the realm of shareholders and C-Suite decision making: far, far away from operational management and employee engagement.
But that is a good place to start…
Increasing profitability occupies a large proportion of the time of company managers – it could even be considered their full time occupation in most companies. There are dozens of ways to increase the profits and profit margins of a company. ActionCOACH offers a checklist of 67 strategies to increase profit margins and 344 strategies to increase profits (drop me a line if you’d like a copy of the checklist). For the most part these strategies involve operational measures that generate more leads, improve sales and customer service processes, increase prices or reduce rework and waste. In fact of the 67 profit margin strategies in this checklist, 56 of them are primarily operational. Only three involve purely executive decisions: reducing directors’ remuneration, investing in technology and restructuring debt. The rest could be considered to require joint deliberation, such as moving to smaller premises, reducing team size or manufacturing more in house.
This emphasis tends to suggest that operational managers have more tools at their disposal to affect profitability, which may then also lead to the corporate bias that they have the greater responsibility for profitability than executives.
But is this the case? How can corporate decisions affect profitability and in so doing enhance or impede the efforts of operational managers? I when I discuss corporate decisions, it does not exclude SMEs or micro-companies – they still make executive/corporate level decisions, but they are made by the same people that make the operational decisions.
To answer these questions, we sampled 719 UK companies employing between 200 and 250 people, representing the larger SMEs in the country. The majority of these companies (n=448) were profitable although a significant number (n=271) were not. Pre-tax profits ranged from £-76,275,000 to £39,915,000.
The data set was randomly split into a training set (n=299 companies) and a test set (347 companies). Information on the following variables was collated for all the companies: turnover, pre-tax profit, number of employees, age of the company, working capital, total current assets, total fixed assets, total current liabilities, total long-term liabilities, shareholder funds, net worth and shareholder capital.
By looking at all possible combinations of these variables it was possible to build a statistical model for the training set. Without going into details of the modelling, it allowed a number of the variables listed above to be excluded and the final model included only the following variables:
- working capital – the greater the working capital, defined as net current assets, the lower the pre-tax profit
- number of employees – the greater the number of employees, the lower the pre-tax profit
- total fixed assets – the greater the total fixed assets, the lower the pre-tax profit
- the greater the share capital, defined as net assets of the company, the greater the pre-tax profit
- share funds per year – the greater the number of shares per year since incorporation the lower the pre-tax profit
These variables explained 73.1% of the variability in the pre-tax profits of the training set and was able to predict whether or not a company was profitable or not with 69.6% accuracy. The model was able to detect profitable companies 76% of the time.
Not perfect, but good enough to offer some insights.
While working capital and number of employees are typically considered to be operational variables, that’s not completely accurate. Executive decisions are clearly involved in leveraging through debt and staffing levels. The other three variables are more clearly based on executive decisions and as we will see in the articles to follow, have a significant effect on profitability.
It is one thing to set goals for operational managers to increase profits and profit margins but the model highlights the need for this to be done in lock step with executive decisions that also influence profitability in ways that are not so commonly considered. Managing the five variables above allows executives to amplify the operational efforts of managers to increase profitability. However, it is clearly also possible for executives and shareholders to impede managers’ efforts, perhaps unwittingly.
In the next article we’ll look more closely at how operational and executive decisions that affect working capital also affect pre-tax profits.