Problems with profits 2

Comments on Problems with profits were interesting, but left me feeling that I wasn't explaining myself very well. I wrote in the post:

I do have real problems, however, with one point you made, the idea of a constantly improving bottom line. I now question whether this is either a desirable or achievable business objective.

The problem here is in part one of definition. I am not saying that firms should not seek to improve performance and profits. Obviously individual managers do need to be aware of the impact of their activities on profitability, although many aren't. However, to my mind, the current mind-sets applied to profit have had some quite pernicious side-effects.

We live in a world of earnings guidance, of short term targets, of performance measurement and rewards against targets. All this just is, although I campaign against it. It's the effects that I am concerned with.

At the most macro-level, I made the point in my last post that when the totality of projected profits exceeded maximum potential profits, then shortfalls were inevitable. There is nothing especially profound in this statement. However, where the gap is a big one institutionalised through reporting arrangements, then the outcome can be instability.

To illustrate with an example, in the late eighties I was involved with the development and marketing of certain financial services. As part of this, I listened to strategic presentations to staff in the US setting out the firm's financial growth targets. The firm in question was an arm of a much bigger bank.

It all sounded wonderful. The problem was that most of the financial institutions were setting targets in the same way. These targets were then institutionalised in unit and personal targets linked to reward systems.

In theory, any one bank could achieve target by increasing market share. In practice, the total of bank targets exceeded what was possible by a substantial margin. The endeavour to maintain target led to some rather creative financial techniques that increased risk, led to a weakening of credit worthiness. This was not properly picked up the banks' internal control mechanisms. The outcome was the financial crash of the late eighties that almost brought the Australian banking system to its knees.

At the start of the period we are talking about, one of my favourite little books was called simply "How to double your profits without really trying." This is still a popular topic. A web search on "how to double your profits" generated 190,000 hits. Titles include: how to double your profits the easy way; how to double your profits by tweaking just two business levers; double your profits in twelve months or less; and so on.

The two core points in the book were that cost reduction flowed straight to the bottom line and therefore gave better results than sales increases; and that the most effective way of reducing costs came from a series of small improvements across cost functions. If your profit margin was 4%, a 1% reduction in a major cost item could have a significant bottom line impact. I liked the book because it was quite a simple language guide.

A fair bit of my professional consulting work has been with professional services firms. Prior to the introduction of more professional management techniques within professional services, it was possible to get very quick paybacks by applying the type of techniques set out in the book. Generally, the greatest gains came from proper time recording systems, thus capturing lost time; from action to improve the translation of WIP (work in progress) to billings; and from faster collection of billings. The first increased the productivity of the existing workforce (personnel payments are by far the biggest cost item in professional services) , the second two improved cash flow and reduced funding costs. The net result was a considerable increase in profit per equity partner. 

By the early 2000s, most of the low hanging fruit had been picked. Further, the costs of the new approaches were becoming clearer. Pressures on staff to maximise billable hours increased staff turnover, while also making it harder to get staff to do other things (marketing is an example). Clients were becoming increasingly concerned about the rising cost of professional advice and began looking for alternatives.

The problem was further complicated by the increasing move of some firms into new areas from the early 1980s in search of profits.

The collapse of Arthur Andersen in 2002 marked a new stage. Over the preceding fifteen or so years, Andersen had tripled the per share income of its partners. Tensions in the firm over the 1990s led to an acrimonious split with consulting partners who formed Accenture. Renamed just Andersen, Andersen moved back into consulting, but then hit the wall in the fall-out from the Enron collapse.

While Andersen is the most spectacular example of collapse, it has not been the only one.

This is not a history of professional services, nor of the structural changes continuing in areas such as accounting and law. Rather, my point is that while the focus on profit improvement did yield results, it also had costs. Profit improvement now involves new approaches, including questions such as the sustainability of profits.

Professional services, especially consulting services, is a leading economic indicator.

In the first months of 1990, the Australian market for business related professional services dropped by one third as businesses started to cut discretionary spend in the face of economic downturn. Business turned from soft consulting such as strategic advice to focus on services that would yield immediate cost reductions.

This was the period of process re-engineering, of retrenchments, of proliferating PIPS (profit improvement programs). New consulting firms emerged whose fees were based on a percentage of costs saved. We came to call them business destruction firms as a parody on cost reduction.

As an example, we had been working with one CEO pulling a major Australian firm together after a tumultuous period that had seen the company on the point of collapse.

The company's troubles dated back to that crazy period of Australian corporate activities especially in the second half of the 1980s. At one point, the company had a manager divestments attempting to sell businesses, while a manager acquisitions was attempting to buy businesses to fit with those the other was trying to sell!

Knowing that they were potentially all for sale, central cohesion collapsed as business units kept their heads down and focused on immediate survival. At our first-cross company marketing workshop, we found business unit CEOs and marketing managers exchanging cards because they had never met each other! We had been making progress, but the then CEO was persuaded to bring cost cutters into the biggest business unit to try to improve immediate profits. The results were bad.

Of course there are circumstances where retrenchment is necessary for company survival. However, the evidence appears to be that companies that restructure and retrench to improve immediate profits through reduced costs rarely achieve sustainable improvements. The problem lies not so much in restructuring costs, although these may be substantial, but in damage done to business culture and operations. A fair number of companies that restructure once need to do so again within two years.

I accept that this is a generalisation. However, it does fit with my personal professional experience.

One of the very interesting studies in this context can be found in Jim Collin's Good to Great. There they found (among other things) that the less performing group used lay-offs as a tool five times more frequently than the best performing group.

Where am I going in all this?

I started with a macro point, that the current focus on profit growth, or at least the form it took, was undeliverable in an aggregate sense and was likely to create instability. I used the banking example to illustrate this.

The subsequent discussion explored some of the implications of the profit focus through a prism set by my own experiences as a management adviser. In my next post, I will look at some further elements here, then set out the overall conclusions I reached.