Every time you receive a mandate to increasea company’s revenue, remember that if you do it withoutthinking about it carefully, you could kill the goose that lays the golden eggs.
By Floris Iking*
It seemsthat everyone agreesto say that increasing a company’s revenue solves many problems. When Private Equity Funds-which usually are focused on increasing revenue over profits -face profitabilityproblems, the common train of thought is “we have to grow to get out ofthistrouble.” However, if not done correctly, they might end up killing the goose that lays the golden eggs.Organizations with this mantratend to lose attentionon determining if the incremental revenue is profitable.Additionally, they are intrinsically taking the risk of adding more costs and complexity to the operationboosting the originalproblem. Growing and addingprofitable revenue to a Company normally solvesmany problems, but not in all the cases. Let’stake alook at this real-life casestudywithout revealingthe Company’sname:
Company “C” produces consumer goods for the retail industry. It was backed by the Private EquityFund “I”(PEFI) andduring the last 5 years consistently delivered positive results. In 2016, the company reported the highest EBITDA (Earnings before Interests, Taxes, Depreciation and Amortization) since its foundation, even thoughitssales remained relatively flat. However, since PEFIwas in the last phase of itstenure as leadinginvestor, EBITDA was put aside,and they were only focused on increasing the sales volume of Company “C”.
Immediately, Company “C” started operating in new markets and opened new commercial channels. However, both the Company “C” and PEFIdid not identifythe new capabilities that should have beingdeveloped in order to achieve such expansion. For example, theysought to increase salesvolumewithout increasingitsproduction. Orders were late, key products were sold out and customers who used to ordered large volumes were extremelyunsatisfied. Overall, this newcomplexity madeCompany’soperations extremely inefficient-especially inproduct delivery–which is an extremelyrelevant variable in the consumer products industry.
At the same time, the main business faced challenges with key customers that demanded preferential prices and product customization, increasing the complexity of the operations. Managers started dedicating their workdays toput out fires; while the business was losingmore than 60 percent of its EBITDA… injusttwo years.
In this example, the intrinsic cause of the decrease in EBITDA was not thelack of additional revenue, but the absence of profitable revenue. The lack of scalable platforms thatcouldadd profitability was the real problemin this case. Revenue increased, but the complexity of business operations increased even morecausing an important impact onthe profitability of the business.
Usually, thedesire to increase the revenue of a certain company is so big that executives do not realize the problems that come with it and how problemssuch as proliferation of new products,dilution of customersand the absence of discipline to manage profitabilitymarginscan decrease the value of the Company. These problems tend to be visible when costs start to consume profits.
In our experience, there is not a common cause for thistype ofsituations,it is a set of variables that generate multiple problems that spreadto the commercial side of the business.Here are some of the most common factors that add costs and complications to the operation and have a negative impact on profitability.
Limited knowledge and unreal expectations:Generally, there is a little clarity about the true causes of profitability of the company. Each area focuses on its individual objectives without seeingand analyzingthe value of the whole organization. Additionally, there is a limited understanding of costs bybusinessarea. Also, there are unreasonable expectations of revenue when comparedto the reality of the market.Precipitated growth strategies: Companies expand into new markets without having a commercial discipline and operational capacity that efficiently contributes torevenueincrease. On the other hand, it is common to launch new product extensions without a carefully consideration of the coststhey will have and theadditionaloperational complexity.
Prices and clients arepoorly managed: Customers who generate fewer annualsales receive the same attention and focus as those who generate the highest sales volume. Furthermore, there is a lack of strategy on price managementand profitability margins that tendsto privilege fixedpricesstrategies and discounts by volume on earnings.Selling for the only purpose of sellingmore: Commercial teams focus on selling, at any cost, with incentives designed to close large volume sales, even if it is not profitable. Redundant business models have also been seen where “everyone sells everything” to achieve the sale of any product on any channel to any customer.
To avoid making the aforementioned mistakes, growth strategies must be based on understanding profitability by product and by customer. Understand what the hidden costs are of serving each clientare, whether due to logistical emergencies, product concessions or special requests.
Customers with higher volumes should have access to better prices and conditions than those who buy smaller volumes. The reality of many companies is governed by the Pareto principle (80-20)andthere is nothing wrong with it, ifand only ifthe margins generated cover the difficulties of serving that 20 percent of the clients.
The platforms where the company’s value proposition is located should be fully utilized to grow on them before accessing others that have not yet been properly developed and which development could take years.Therefore, every time you hear the mandate to increase revenue, remember that if you do it without thinking about it, you could be killing the goose that lays the golden eggs.
*Floris Iking is founder, partner and managing director in Alvarez & Marsal Mexico.