How to map your industry's profit pool

Many managers chart strategy without a full understanding of the sources and distribution of profits in their industry. Sometimes they focus their sights on revenues instead of profits, mistakenly assuming that revenue growth will eventually translate into profit growth. In other cases, they simply lack the data or the analytical tools required to isolate and measure variations in profitability. In this Manager's Tool Kit, the authors present a way to think clearly about where the money's being made in any industry. They describe a framework for analyzing how profits are distributed among the activities that form an industry's value chain. Such an analysis can provide a company's managers with a rich understanding of their industry's profit structure--what the authors call its profit pool--enabling them to identify which activities are generating disproportionately large or small shares of profits. Even more important, a profit-pool map opens a window onto the underlying structure of the industry, helping managers see the various forces that are determining the distribution of profits. As such, a profit-pool map provides a solid basis for strategic thinking. Mapping a profit pool involves four steps: defining the boundaries of the pool, estimating the pool's overall size, estimating the size of each value-chain activity in the pool, and checking and reconciling the calculations. The authors briefly describe each step and then apply the process by providing a detailed example of a hypothetical retail bank. They conclude by looking at ways of organizing the data in chart form as a first step toward plotting a profit-pool strategy.     

SPECIFIC KNOWLEDGE AND DIVISIONAL PERFORMANCE MEASUREMENT

This paper discusses five common divisional performance measurement methods—cost centers, revenue centers, profit centers, investment centers, and expense centers—and provides the beginnings of a theory that attempts to explain when each of these five methods is likely to be the most efficient. The central insight of the theory is that each of these methods offers an alternative way of aligning decision-making authority with valuable "specific knowledge" inside the organization.
The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers—defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions—tend to supplant revenue and cost centers when the line managers have a significant informational advantage over headquarters and when there are few interdependencies (or "synergies") between divisions. Investment centers—that is, profit centers in which unit managers are allowed to make major investment decisions—tend to prevail when the activity is capital-intensive and when it is difficult for headquarters to identify the value-maximizing investment strategy.
In evaluating the performance of profit centers, rate-of-return performance measures like RONA (return on net assets) are likely to be effective when unit managers have little influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single-period measure of performance because it is best designed to encourage value-maximizing investment decisions.     

Specific Knowledge and Divisional Performance Measurement

This classic by the formulators of agency cost theory discusses five common divisional performance measurement methods—cost centers, revenue centers, profit centers, investment centers, and expense centers—while providing a theory that attempts to explain when each of these methods is likely to be the most efficient. The central insight of the theory is that each method offers a different way of aligning decision-making authority with valuable "specific knowledge" inside the organization.
The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers—defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions—tend to supplant revenue and cost centers when line managers have a significant informational advantage over headquarters and when there are few interdependencies (or "synergies") between divisions. Investment centers—profit centers in which unit managers are allowed to make major investment decisions—tend to prevail when the activity is capital-intensive and when it is difficult for headquarters to identify the value-maximizing investment strategy.
In evaluating the performance of profit centers, rate-of-return measures like ROA are likely to be effective when unit managers do not have major influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single-period measure because it is designed to encourage only value-increasing investment decisions.     

M&A needn't be a loser's game

Three out of four acquisitions fail; they destroy wealth for the buyer's shareholders, who end up worse off than they would have been had the deal not been done. But it doesn't have to be that way, argue the authors. In evaluating acquisitions, companies must look beyond the lure of profits the income statement promises and examine the balance sheet, where the company keeps track of capital. It's ignoring the balance sheet that causes so many acquisitions to destroy shareholders' wealth. Unfortunately, most executives focus only on sales and profits going up, never realizing that they've put in motion a plan to destroy their company's true profitability--its return on invested capital. M&A, like other aspects of running a company, works best when seen as a way to create shareholder value through customers. Some deals are sought to help create better value propositions for the business or to better execute current strategies--or to block competitors from doing these things. But most deals are about customers and should start with an analysis of customer profitability. Some customers are deliciously profitable; others are dismal money losers. The better an acquirer understands the profitability of its own customers, the better positioned it will be to perform such analyses on other companies. In this article, the authors show that customer profitability varies far more dramatically than most managers suspect. They also describe how to measure the profitability of customers. By understanding the economics of customer profitability, companies can avoid making deals that hurt their shareholders, they can identify surprising deals that do create wealth, and they can salvage deals that would otherwise be losers.     

Hedging customers

You are a marketing director with $5 million to invest in customer acquisition and retention. Which customers do you acquire, and which do you retain? Up to a point, the choice is obvious: Keep the consistent big spenders and lose the erratic small ones. But what about the erratic big spenders and the consistent small ones? It's often unclear whether you should acquire or retain them and at what cost. Businesses have begun dealing with unpredictable customer behavior by following the practices of sophisticated investors who own portfolios comprising dozens of stocks with different, indeed divergent, histories and prospects. Each portfolio is diversified so as to produce the investor's desired returns at the particular level of uncertainty he or she can tolerate. Customers, too, are assets--risky assets. As with stocks, the cost of acquiring them is supposed to reflect the cash-flow values they are likely to generate. The authors explain how to construct a portfolio based on the notion that a customer's risk-adjusted lifetime value depends on its anticipated effect on the riskiness of the group it is joining. They also show how this approach was used to identify the best prospects for Myron Corporation, a global leader in the personalized business-gift industry. The concept of risk-adjusted lifetime value has a transforming power: For companies that rely on it, product managers will be replaced by customer managers, and the current method of accounting for profit and loss--which is by product--will be replaced by one that determines each customer's P&L. Once adjusted for risk, those P&Ls will become the firm's key performance and operational metric.     

Making business sense of the Internet

For managers in large, well-established businesses, the Internet is a tough nut to crack. It is very simple to set up a Web presence and very difficult to create a Web-based business model. Established businesses that over decades have carefully built brands and physical distribution relationships risk damaging all they have created when they pursue commerce through the Net. Still, managers can't avoid the impact of electronic commerce on their businesses. They need to understand the opportunities available to them and recognize how their companies may be vulnerable if rivals seize those opportunities first. Broadly speaking, the Internet presents four distinct types of opportunities. First, it links companies directly to customers, suppliers, and other interested parties. Second, it lets companies bypass other players in an industry's value chain. Third, it is a tool for developing and delivering new products and services to new customers. Fourth, it will enable certain companies to dominate the electronic channel of an entire industry or segment, control access to customers, and set business rules. As he elaborates on these four points, the author gives established companies a systematic way to sort through the risks and rewards of doing business in cyberspace.     

Discovering new points of differentiation

Most profitable strategies are built on differentiation: offering customers something they value that competitors don't have. But most companies concentrate only on their products or services. In fact, a company can differentiate itself every point where it comes in contact with its customers--from the moment customers realize they need a product or service to the time when they dispose of it. The authors believe that if companies open up their thinking to their customer's entire experience with a product or service--the consumption chain--they can uncover opportunities to position their offerings in ways that neither they nor their competitors though possible. The authors show how even a mundane product such as candles can be successfully differentiated. By analyzing its customers' experiences and exploring various options, Blyth Industries, for example, has grown from a $2 million U.S. candle manufacturer into a global candle and accessory business with nearly $500 million in sales and a market value of $1.2 billion. Finding ways to differentiate one's company is a skill that can be nurtured, the authors contend. In this Manager's Tool Kit, they have designed a two-part approach that can help companies continually identify new points of differentiation and develop the ability to generate successful differentiation strategies. "Mapping the Consumption Chain" captures the customer's total experience with a product or service. "Analyzing Your Customer's Experience" shows managers how directed brainstorming about each step in the consumption chain can elicit numerous ways to differentiate any offering.     

Strategy as revolution

How often does the strategic-planning process start with senior executives asking what the rest of the organization can teach them about the future? Not often enough, argues Gary Hamel. In many companies, strategy making is an elitist procedure and ?strategy? consists of nothing more than following the industry's rules. But more and more companies, intent on overturning the industrial order, are rewriting those rules. What can industry incumbents do? Either surrender the future to revolutionary challengers or revolutionize the way their companies create strategy. What is needed is not a tweak to the traditional strategic-planning process, Hamel says, but a new philosophical foundation: strategy is revolution. Hamel offers ten principles to help a company think about the challenge of creating truly revolutionary strategies. Perhaps the most fundamental principle is that so-called strategic planning doesn't produce true strategic innovation. The traditional planning process is little more than a rote procedure in which deeply held assumptions and industry conventions are reinforced rather than challenged. Such a process harnesses only a tiny proportion of an organization's creative potential. If there is to be any hope of industry revolution, senior managers must give up their monopoly on the creation of strategy. They must embrace a truly democratic process that can give voice to the revolutionaries that exist in every company. If senior managers are unwilling to do this, employees must become strategy activists. The opportunities for industry revolution are mostly unexplored. One thing is certain: if you don't let the revolutionaries challenge you from within, they will eventually challenge you from without--in the marketplace.     

Managing price, gaining profit

The fastest and most effective way for a company to realize maximum profit is to get its pricing right. The right price can boost profit faster than increasing volume will; the wrong price can shrink it just as quickly. Yet many otherwise tough-minded managers miss out on significant profits because they shy away from pricing decisions for fear that they will alienate their customers. Worse, if management isn't controlling its pricing policies, there's a good chance that the company's clients are manipulating them to their own advantage. McKinsey & Company's Michael Marn and Robert Rosiello show managers how to gain control of the pricing puzzle and capture untapped profit potential by using two basic concepts: the pocket price waterfall and the pocket price band. The pocket price waterfall reveals how price erodes between a company's invoice figure and the actual amount paid by the customer--the transaction price. It tracks the volume purchase discounts, early payment bonuses, and frequent customer incentives that squeeze a company's profits. The pocket price band plots the range of pocket prices over which any given unit volume of a single product sells. Wide price bands are commonplace: some manufacturers' transaction prices for a given product range 60%; one fastener supplier's price band ranged up to 500%. Managers who study their pocket price waterfalls and bands can identify unnecessary discounting at the transaction level, low-performance accounts, and misplaced marketing efforts. The problems, once identified, are typically easy and inexpensive to remedy.     

Innovation versus complexity: what is too much of a good thing?

What's the number of product or service offerings that would optimize both your revenues and your profits? For most firms, it's considerably lower than the number they offer today. The fact is, companies have strong incentives to be overly innovative in new product development. But continual launches of new products and line extensions add complexity throughout a company's operations, and as the costs of managing that complexity multiply, margins shrink. To maximize profit potential, a company needs to identify its innovation fulcrum, the point at which an additional offering destroys more value than it creates. The usual antidotes to complexity miss their mark because they treat the problem on the factory floor rather than at its source: in the product line. Mark Gottfredson and Keith Aspinall of Bain & Company present an approach that goes beyond the typical Six Sigma or lean-operations program to root out complexity hidden in the value chain. The first step is to ask, What would our company look like if it made and sold only a single product or service? In other words, you identify your company's equivalent of Henry Ford's one-size-fits-all Model T-for Starbucks, it might be a medium-size cup of coffee; for a bank, a simple checking account-and then determine the cost of producing that baseline offering. Next, you add variety back into the business system, product by product, and carefully forecast the resulting impact on sales as well as the cost implications across the value chain. When the analysis shows the costs beginning to overwhelm the added revenues, you've found your innovation fulcrum. By deconstructing their companies to a zero-complexity baseline, managers can break through organizational resistance and deeply entrenched ways of thinking to find the right balance between innovation and complexity.     

Managing the right tension

Of all the competing objectives every company faces, three pairs stand out: profitability versus growth, the short term versus the long term, and the whole organization versus the units. In each case, progress on one front usually comes at the expense of progress on the other. The authors researched the performance of more than 1000 companies worldwide over the past two decades and found that most struggle to succeed across the three tensions. From 1983 to 2003, for example, only 32% of these companies more often than not achieved positive profitability and revenue growth at the same time. The problem, the authors discovered, is not so much that managers don't recognize the tensions--those are all too familiar to anyone who has ever run a business. Rather, it is that managers frequently don't focus on the tension that matters most to their company. Even when they do identify the right tension, they usually make the mistake of prioritizing a "lead" objective within it-for example, profitability over growth. As a result, companies often end up moving first in this direction, then in that, and then back again, never quite resolving the tension. The companies that performed best adopted a very different approach. Instead of setting a lead objective, they looked at how best to strengthen what the two sides of each tension have in common: For profitability and growth,the common bond is customer benefit; for the short term and the long, it is sustainable earnings; and for the whole and its parts, it is particular organizational resources and capabilities. The authors describe how companies can select the right tension, what traps they may fall into when they focus on one side over the other, and how to escape these traps by managing to the bonds between objectives.     

Mastering the value chain. An interview with Mark Levin of Millennium Pharmaceuticals. Interview by David Champion.

As today's business leaders are all too aware, a new scientific or technological break-through can quickly transform an industry's competitive landscape. The upheaval is often traumatic for the companies involved, forcing them to rethink their strategies and redefine their boundaries. But an industry in flux also creates vast opportunities. To seize them, companies must see how the current upheavals will affect the future distribution of profits--and then reinvent themselves to capitalize on the new sources of value. In this interview with HBR senior editor David Champion, Mark Levin, the founder and CEO of Millennium Pharmaceuticals, describes his vision of the future of the pharmaceutical industry in the wake of the genetics revolution and new technologies that have altered the economics of drug development. No company, he argues, will create serious long-term value by staying in just one or two stages of the value of chain. That's why Millennium, which started out doing basis research into genes and proteins and selling its findings to pharmaceutical giants, has moved downstream - toward the patients who actually use and pay for the drugs. He explains why the research end has become less lucrative than the more mechanical tasks of identifying, testing, and manufacturing molecules. Levin talks about the changes Millennium has undergone since its inception in 1993-from 30 workers to more than 1,000, and from one end of the value chain to the other. He discusses the company's cultural transformations as well as the partnerships and acquisitions that have helped millennium become involved in every stage of the chain-from gene to patient. Levin's vigorous approach to balancing long-term strategy with short-term tactics offers important lessons to any executive facing an industry upheaval.     

Capital versus talent. The battle that's reshaping business

For much of the twentieth century, labor and capital fought bitterly for control of the industrialized economy. The titans of industry ultimately won a resounding victory over the unions, but the story doesn't end there. In today's economy, value is largely the product of knowledge and information. Companies cannot generate profits without the ideas, skills, and leadership capabilities of knowledge workers. It's these factors--not technologies, not factories, and certainly not capital--that give the most successful companies their unique advantages. As knowledge workers come to realize this, and see that the demand for their talent outstrips the supply, they are steadily wresting more and more of the profits from shareholders. This time the battle is between the sources of capital and the producers of value, and how it will end is far from clear. The roots of the current conflict lie in the twentieth-century shift from industrial to managerial capitalism and the creation of a new class of professional talent, the authors explain. Since the arrival of the information-based economy in the past decade, tensions have escalated. The dramatic rise of CEO pay--and the public fire it has drawn--is a telling symptom. With this new battle, we're also witnessing a fundamental change in the political alignment of capital. The Left is now siding with "the common shareholder" against the well-compensated top tier of the labor pool. Shareholders seeing an unprecedented proportion of the return on their investments siphoned off to employees may well ask, is there no end to it? Increasingly, it's human capital that is the basis of value, and financial capital has become far more generic than shareholders would like to believe. The growing tensions between shareholders and managers cannot be ignored, and capitalism is at a crossroads--again.     

Creating new market space.

Most companies focus on matching and beating their rivals. As a result, their strategies tend to take on similar dimensions. What ensues is head-to-head competition based largely on incremental improvements in cost, quality, or both. The authors have studied how innovative companies break free from the competitive pack by staking out fundamentally new market space--that is, by creating products or services for which there are no direct competitors. This path to value innovation requires a different competitive mind-set and a systematic way of looking for opportunities. Instead of looking within the conventional boundaries that define how an industry competes, managers can look methodically across them. By so doing, they can find unoccupied territory that represents real value innovation. Rather than looking at competitors within their own industry, for example, managers can ask why customers make the trade-off between substitute products or services. Home Depot, for example, looked across the substitutes serving home improvement needs. Intuit looked across the substitutes available to individuals managing their personal finances. In both cases, powerful insights were derived from looking at familiar data from a new perspective. Similar insights can be gleaned by looking across strategic groups within an industry; across buyer groups; across complementary product and service offerings; across the functional-emotional orientation of an industry; and even across time. To help readers explore new market space systematically, the authors developed a tool, the value curve, that can be used to represent visually a range of value propositions.     

The timeliness of performance information in determining executive compensation

We study whether boards of directors concentrate on performance near compensation decision times rather than providing consistent incentives for chief executive officers (CEO) throughout the fiscal year. We show empirically that managers can profit by moving sales revenue among fiscal quarters. Though this may suggest that boards use short-term trends when determining rewards, we find evidence consistent with boards tying pay to recent sales growth so as to use the best information about future performance. We also find that the timing of profits throughout the year does not affect CEO pay, which may suggest that smoothing firm income is important to CEOs.     

The path of kyosei

Many global companies believe they have a moral duty to respond to the world's problems but are unsure how to do that and still pursue a reasonable profit for their shareholders. Ryuzaburo Kaku, honorary chairman of Canon, the Japanese technology company, suggests that companies consider kyosei, a business credo that he defines as a "spirit of cooperation" in which individuals and organizations work together for the common good. Kyosei, Kaku claims, has helped Canon make a significant and positive impact on many world problems as the company has grown to become one of the world's preeminent innovators and manufacturers of technology. The implementation of kyosei can be divided into five stages, with each stage building on the preceding one. In the first stage, companies must work to secure a predictable stream of profits and to establish strong market positions. From this foundation, they move on to the second stage, in which managers and workers resolve to cooperate with each other, recognizing that both groups are vital to the company's success. In the third stage, this sense of cooperation is extended beyond the company to encompass customers, suppliers, community groups, and even competitors. At the fourth stage, a company takes the cooperative spirit beyond national boundaries and addresses some of the global imbalances that plague the world. In the fifth stage, which companies rarely achieve, a company urges its national government to work toward rectifying global imbalances. For each stage, Kaku provides detailed examples from Cannon's own experience in putting the ideas of kyosei into practice.     

The sales learning curve

When a company launches a new product into a new market, the temptation is to immediately ramp up sales force capacity to gain customers as quickly as possible. But hiring a full sales force too early just causes the firm to burn through cash and fail to meet revenue expectations. Before it can sell an innovative product efficiently, the entire organization needs to learn how customers will acquire and use it, a process the authors call the sales learning curve. The concept of a learning curve is well understood in manufacturing. Employees transfer knowledge and experience back and forth between the production line and purchasing, manufacturing, engineering, planning, and operations. The sales learning curve unfolds similarly through the give-and-take between the company--marketing, sales, product support, and product development--and its customers. As customers adopt the product, the firm modifies both the offering and the processes associated with making and selling it. Progress along the manufacturing curve is measured by tracking cost per unit: The more a firm learns about the manufacturing process, the more efficient it becomes, and the lower the unit cost goes. Progress along the sales learning curve is measured in an analogous way: The more a company learns about the sales process, the more efficient it becomes at selling, and the higher the sales yield. As the sales yield increases, the sales learning process unfolds in three distinct phases--initiation, transition, and execution. Each phase requires a different size--and kind--of sales force and represents a different stage in a company's production, marketing, and sales strategies. Adjusting those strategies as the firm progresses along the sales learning curve allows managers to plan resource allocation more accurately, set appropriate expectations, avoid disastrous cash shortfalls, and reduce both the time and money required to turn a profit.     

Managing in an age of modularity

Modularity is a familiar principle in the computer industry. Different companies can independently design and produce components, suck as disk drives or operating software, and those modules will fit together into a complex and smoothly functioning product because the module makers obey a given set of design rules. Modularity in manufacturing is already common in many companies. But now a number of them are beginning to extend the approach into the design of their products and services. Modularity in design should tremendously boost the rate of innovation in many industries as it did in the computer industry. As businesses as diverse as auto manufacturing and financial services move toward modular designs, the authors say, competitive dynamics will change enormously. No longer will assemblers control the final product: suppliers of key modules will gain leverage and even take on responsibility for design rules. Companies will compete either by specifying the dominant design rules (as Microsoft does) or by producing excellent modules (as disk drive maker Quantum does). Leaders in a modular industry will control less, so they will have to watch the competitive environment closely for opportunities to link up with other module makers. They will also need to know more: engineering details that seemed trivial at the corporate level may now play a large part in strategic decisions. Leaders will also become knowledge managers internally because they will need to coordinate the efforts of development groups in order to keep them focused on the modular strategies the company is pursuing.     

Countering the biggest risk of all

Corporate treasurers and chief financial officers have become adept at quantifying and managing a wide variety of risks: financial (for example, currency fluctuations), hazard (chemical spills), and operational (computer system failures). To defend themselves, they use tried-and-true tools such as hedging, insurance, and backup systems. Some companies have even adopted the concept of enterprise risk management, integrating available risk management techniques in a comprehensive, organization-wide approach. But most managers have not addressed in a systematic way the greatest threat of all--strategic risks, the array of external events and trends that can devastate a company's growth trajectory and shareholder value. Strategic risks go beyond such familiar challenges as the possible failure of an acquisition or a product launch. A new technology may overtake your product. Gradual shifts in the market may slowly erode one of your brands beyond the point of viability. Or rapidly shifting customer priorities may suddenly change your industry. The key to surviving these strategic risks, the authors say, is knowing how to assess and respond to them. In this article, they lay out a method for identifying and responding to strategic threats. They categorize the risks into seven major classes (industry, technology, brand, competitor, customer, project, and stagnation) and describe a particularly dangerous example within each category. The authors also offer countermeasures to take against these risks and describe how individual companies (American Express, Coach, and Air Liquide, among them) have deployed them to neutralize a threat and, in many cases, capitalize on it. Besides limiting the downside of risk, strategic-risk management forces executives to think more systematically about the future, thus helping them identify opportunities for growth.     

Where value lives in a networked world

While many management thinkers proclaim an era of radical uncertainty, authors Sawhney and Parikh assert that the seemingly endless upheavals of the digital age are more predictable than that: today's changes have a common root, and that root lies in the nature of intelligence in networks. Understanding the patterns of intelligence migration can help companies decipher and plan for the inevitable disruptions in today's business environment. Two patterns in network intelligence are reshaping industries and organizations. First, intelligence is decoupling--that is, modern high-speed networks are pushing back-end intelligence and front-end intelligence toward opposite ends of the network, making the ends the two major sources of potential profits. Second, intelligence is becoming more fluid and modular. Small units of intelligence now float freely like molecules in the ether, coalescing into temporary bundles whenever and wherever necessary to solve problems. The authors present four strategies that companies can use to profit from these patterns: arbitrage allows companies to move intelligence to new regions or countries where the cost of maintaining intelligence is lower; aggregation combines formerly isolated pieces of infrastructure intelligence into a large pool of shared infrastructure provided over a network; rewiring allows companies to connect islands of intelligence by creating common information backbones; and reassembly allows businesses to reorganize pieces of intelligence into coherent, personalized packages for customers. By being aware of patterns in network intelligence and by acting rather than reacting, companies can turn chaos into opportunity, say the authors.