In this article, we explain the importance of strategic thinking based on data, which inspired the creation of the web-based training program “Real Profitability” by the Strategy Academy.
One of the concerns that has stolen the sleep of CEOs in recent years is the progressive increase in the complexity of their organizations. The dynamic and agile process of creating new strategies has fueled a provocative paradox: on the one hand, it is vital for maintaining the company's relevance over time, protecting the brand from competition and ensuring resilience in this age of uncertainty. On the other hand, with each new product or service incorporated into the mix and each new customer segment that the company adds to its strategy, it increases its costs of producing and serving markets efficiently and generating value, and expands the number of variables that leaders have to manage on a daily basis. Even if the company adds more technologies to increase the productivity of processes and management, Executives' time remains limited and disputed by the countless work fronts that demand attention on a daily basis.
Other necessary advances also add complexity to operations, such as improving governance and compliance mechanisms, which are fundamental to increasing corporate security and mitigating strategic risks. However, in many cases they inevitably slow down decision-making and the agile reaction to changes in context.
The current context calls for courageous and rapid decisions
The COVID-19 pandemic has paralyzed several sectors of the economy and caused a crisis in countless companies. On the one hand, this scenario has accelerated organizational and digital transformation movements that had been moving at a slow pace. However, the hit to revenues has forced leaders to make decisions to cut spending, hastily reduce structures, outsource and simplify activities, giving up competitiveness in various elements of the strategy. The main concern of leaders today is to ensure the survival of the company while they go through this perfect storm that we are all going through.
If resources were already finite, they are now even more restricted and require discipline in prioritizing the activities, products and customer segments that are really essential for the company's real profitability. The risk of lack of focus is now much higher and more dangerous for the company's sustainability.
However, we have come across a very common difficulty faced by managers in all companies: figuring out which are the main sources that generate economic value, and creating strategies to foster these engines of prosperity, while at the same time deciding how to deal with parts of the mix and customer segments that are not significant for the sustainability of the business - some need to be maintained in some less complex and costly way, while others can simply be eliminated.
In our strategic consulting projects, we have successfully applied the Real Profitability method from the point of view of Pareto's Natural Law of business - the 80/20 rule. This is an effective analytical method for measuring economic value and guiding the process of continuous improvement in profitability. As a measure of value, it clarifies and shows the real profitability of products (services) and clients, adjusted for the cost of complexity - a profit devoid of any bias and accounting allocation, or even a profit and loss account for each solution offered to the market.
As a strategic management process, Real Profitability makes it possible to separate the few vital activities and solutions from the many trivial ones. It provides a data-based method for decision-making and generating insights, so that companies can focus on the markets and solutions that generate the most economic results, reducing efforts on low-value activities and products that carry a higher cost of complexity. This focus on vital business sectors becomes even more important during and after times of crisis, such as the one we are currently experiencing.
Real Profitability is key to strategic decision-making
Given that companies are finite pools of resources and leadership is increasingly pressed for time, the process of creating strategy requires making good choices and non-choices. Real Profitability is a valuable methodology to help leadership define strategic focus, providing a more precise resource allocation logic.
In this sense, a more effective way of comparing the different sources of revenue, business units or market segments would be to classify the portfolio of clients and solutions according to the Pareto Principle and the Contribution Margin (in Reais) of each transaction. This simple correlation, as illustrated in the figure below, identifies important differences in the value and complexity of activities, forming the analytical basis of Real Profitability.
Sector 1 (called the Core) is usually responsible for 70% or more of revenue and profit - and the lowest cost of complexity. Intuitively, it is always easier to sell a few high-volume items to a few customers than to sell many low-volume items to many customers. The core of the business is the most important area and the focus of growth and improvement strategies. We must know everything about the few customers and solutions in this sector, as well as drawing up growth, profitability improvement and innovation strategies that will strengthen the uniqueness of the business. In fact, we should treat this sector as if it were a separate business!
Sector 2 contains secondary customers, who generate around 12% of revenues and profits, depending on the situation. This is a smaller customer base, where we can automate service more and reduce transactional costs by applying market development (mining for future core customers) and segmentation strategies. Differentiation strategies between core and secondary customers are extremely important.
Sector 3 also generates approximately 12% of revenues and profits, and is largely responsible for the proliferation of products and suppliers. The most important strategies for this sector are related to reducing the complexity of solutions, rationalizing suppliers, customizing products and services and outsourcing. Modularity strategies are applied in this sector to allow an increase in scale, without a significant increase in complexity costs.
As for Sector 4 (Residual), it generates only a small part of the revenue and profit, but is responsible for most of the cost of complexity. This is due to the greater number of low-value transactions that take place in this sector. Here, executives must develop methods of filtering out new products and services, reducing the size of this sector as much as possible. Simply recognizing that we should not focus the company's strategy (and resources) on this sector (non-choice) represents a huge step forward in the process.
Real Profitability provides a quantitative dimension for a more objective and granular analysis of company performance. It facilitates the convergence of leadership during the strategic reflection process, supported by relevant data, to help make good choices and non-choices of your Value Propositions - the mix and benefits to the market that constitute the core element of your Business Model. We start with the type of correlation exemplified above and end up with a plethora of insights and conclusions to support strategic decisions. Through quantitative analysis of the product and customer portfolio, executives can compare different market segments and product lines on the basis of real profit, i.e. taking into account the economic effectiveness of each business segment.
Benefits of the Real Profit methodology in the creation and execution of Strategies
We can say that Real Profitability and Pareto analysis are valuable tools for improving the development and execution of strategy by providing:
1. Greater objectivity in the selection and comparison of vital initiatives, because it allows the use of more precise quantitative methods, without the common biases of conventional accounting. Objectivity avoids proliferation and helps to purify strategic initiatives, making it easier for the organization to communicate and understand the strategy.
2. Greater agility in executing the strategy. By segmenting the business into smaller units focused on highly profitable niches, Real Profitability helps to implement the strategy. It makes it possible to adopt a decentralized approach, involving the heads of the business units and middle managers in carrying out their respective strategies, in harmony with the whole. This is one of the reasons why large conglomerates, with numerous autonomous business units, use this method.
3. The analytical basis improves strategy governance by reallocating resources between strategic initiatives in an agile and precise manner. When markets change direction, for example, companies need to respond quickly by reallocating talent and capital. The analytical method based on the value of activities, solutions and clients allows for a more objective assessment of the strategy's progress, compared to other more subjective KPIs.
Luzio Strategy's experience shows that by applying Real Profitability during the strategy creation process, we have greater clarity about the opportunities for optimizing current business models - and creating new ones. In the execution of the strategy, it offers greater certainty in the design of tactical plans and comes back later to influence thinking in subsequent strategic reflection cycles. The design of revenue growth strategies usually begins with an empirical (sometimes intuitive) exercise, and evolves to be complemented by an analytical approach based on data. Quantitative analysis provides the shock of invisible reality, allowing for greater selectivity and focus on the most valuable market segments to be pursued.
Over time, by clarifying the most relevant sources of value generation, new strategies can become bolder and more realistic. And so Real Profitability helps mobilize a high-performance culture, based on facts and results that are clear to all Stakeholders.
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