Achieving Sustainable Success: A Framework for Maximizing Profit

Management teams are consistently seeking ways to position their companies to navigate business cycles successfully while maintaining growth. Achieving this goal hinges on optimizing profit targets. While many organizations invest efforts into profit optimization, success often eludes them due to a lack of a robust framework for setting targets and executing strategies effectively.

In periods of economic uncertainty, such as potential recessions, revenue growth projections and cash flows can become uncertain. Inflationary pressures can drive up wages, material costs, and operating expenses, impacting profitability unless offset by price adjustments or other strategic levers. Additionally, rising interest rates can further squeeze returns on invested capital, especially for businesses with unhedged floating-rate debt.

However, challenging times also present opportunities for leadership to proactively address financial challenges. This involves reviewing internal processes, vendor agreements, product portfolios, pricing strategies, and other operational factors to optimize margins and align business strategies with key objectives. Efficient resource allocation enables swift and confident decision-making in the face of economic headwinds, positioning the company to capitalize on growth opportunities when conditions improve.

In this article, I present a four-step strategic process for defining and implementing profitability optimization initiatives, focusing on EBITDA margins to isolate operational profitability from noncash impacts like depreciation and amortization.

Step 1: Define Optimal Profitability and Establish Targets

Setting clear profitability targets is crucial for strategic planning. Avoid falling into the trap of relying solely on historical data to establish future targets, as this approach may limit your understanding of the business’s true potential. Instead, leverage historical data as a reference point while considering changing circumstances and market dynamics.

For instance, if a company historically maintained an average EBITDA margin of 13% over the past three years but is currently experiencing a decrease to 9% due to external factors, setting a target solely based on historical averages (e.g., restoring margins to 13%) may not reflect the business’s actual potential.

To define optimal profitability, assess the company’s capabilities and market conditions comprehensively. Analyze industry benchmarks, competitive landscape, operational efficiencies, and growth opportunities. This holistic approach ensures that profitability targets are aligned with the company’s long-term strategic objectives and growth potential.

Example: Consider ABC Co., a hypothetical HR and payroll software company with a current EBITDA margin of 15% and a five-year historical average of 13.5%. While ABC Co. has demonstrated strong performance, its leadership should not be complacent. By evaluating market trends, technological advancements, and operational efficiencies, ABC Co. can identify opportunities to exceed historical performance and achieve sustainable growth.

By defining optimal profitability based on comprehensive assessments rather than historical averages alone, companies can set ambitious yet achievable targets that drive long-term success and value creation for stakeholders.

By pulling individual company data for competitors and performing additional industry and market research, it’s possible to establish industry average EBITDA margins, as well as margins for similarly sized companies. This data is readily available for public companies; for private companies, you may only be able to obtain it through a paid service like D&B Hoovers, IBISWorld, or Pitchbook. If your business is having difficulty accessing this information or finding quality data, a good finance and strategy consultant will be able to help provide benchmarking data and to conduct a thorough analysis with actionable conclusions.

In the case of ABC Co., we’ll establish that its best-in-class EBITDA margins for its industry are in the 28% range, per IBISWorld research. At this point, ABC Co. can establish a few benchmarking scenarios for what its own optimal EBITDA margin could be—best in class, high performer, industry average, or comparable to an average similarly sized company. With this information in hand, management can then begin evaluating performance against these benchmarks to establish which one might be attainable.

Let’s assume ABC Co. management has established the following benchmarks to measure the company against, and set these associated targets. These benchmarks compare ABC Co.’s current performance against the best in class, high performers, industry average, and the average of companies of similar size. When conducting this exercise you should establish benchmarks with a similar logic.

Step 2: Identifying Levers to Optimize Profitability

After establishing benchmarks and targets, ABC Co.’s management proceeds to identify operational levers that will drive improved profitability, beginning with a focus on achieving high-performer EBITDA margins.

In my experience working with clients, there’s often a tendency to concentrate solely on reducing operating expenses to boost profitability. While cost optimization is essential, neglecting revenue and gross margin improvement can overlook significant opportunities to enhance EBITDA margins. Therefore, a comprehensive strategy should address both cost efficiencies and revenue enhancement to maximize profitability sustainably.

When analyzing operational levers, I recommend taking a top-down approach starting with revenue factors. Key questions to consider include:

• Which revenue factors have the most significant impact on EBITDA margins?
• Over which of these factors does management have the most control?
• Which factors can differentiate the business and establish a competitive advantage?

Key areas for consideration typically include:

1. Product Offerings: Evaluate product mix, quality, pricing strategy, return rates, adoption rates, and success in cross-selling or upselling. Improvements in these areas can directly impact gross profit margins, thereby enhancing EBITDA margins.
2. Sales Operations: Analyze units sold, higher-margin sales, sales cycle times, and win rates to identify opportunities for sales process optimization.
3. Customer Satisfaction: While not directly reflected in financial statements, customer satisfaction metrics such as net promoter scores, customer reviews, churn rates, and customer service interactions are vital. Satisfied customers lead to reduced churn, higher repeat purchases, and lower customer acquisition costs.
4. Operating Efficiency: Focus on optimizing operating expenses relative to revenue, employee productivity metrics, and return on investments in areas like marketing and operations.

By conducting internal and external benchmarking, ABC Co. assessed various drivers of EBITDA margin performance, comparing internal metrics against industry and competitor benchmarks. This analysis reveals critical areas where operational improvements can drive profitability and competitive positioning.

Example Analysis: ABC Co.’s assessment highlighted areas where the company is lagging behind industry benchmarks, particularly in areas related to product offerings, sales operations, customer satisfaction, and operating efficiency. By focusing on these key levers, ABC Co. aims to optimize EBITDA margins incrementally, setting a foundation for sustained profitability improvements over time without overwhelming its workforce. This iterative approach ensures that improvement initiatives are manageable and aligned with the organization’s long-term goals.

Step 3: Sensitizing and Prioritizing Margin Improvement Initiatives

After identifying key areas of opportunity for margin expansion, ABC Co. moves on to sensitizing and prioritizing improvement initiatives based on their potential impact on EBITDA margins. This step involves assessing the degree of control over each opportunity, time required for implementation, potential improvement achievable, and overall impact on margins.

Factors to Consider for Each Improvement Opportunity:

1. Degree of Control: Evaluate the extent to which management can influence or control each improvement opportunity.
2. Implementation Time: Assess the time required to implement changes that significantly impact margins.
3. Potential Improvement: Determine the realistic potential improvement achievable by addressing each opportunity.
4. Impact on Margins: Understand how each metric or initiative directly impacts EBITDA margins.

To prioritize initiatives effectively, ABC Co. can use a dynamic operating model in Excel that incorporates key performance drivers as independent variables. This model allows management to measure the impact of each variable in isolation, identifying the most impactful initiatives for margin improvement.

Example: Using an operating model, ABC Co. calculates the sensitivities of selected operating levers to EBITDA margins. This sensitivity analysis measures the percentage change in EBITDA margin for each 1% improvement in the identified levers. The results of this analysis provide insights into the relative importance of each improvement opportunity and guide resource allocation towards the most impactful initiatives.

Sample Sensitivity Analysis: ABC Co.’s sensitivity analysis reveals the impact of various improvement initiatives on EBITDA margins:

• Improving communication of product value: 1% improvement results in 1.5% increase in EBITDA margin.
• Enhancing pricing strategy: 1% improvement results in 2.0% increase in EBITDA margin.
• Optimizing sales processes: 1% improvement results in 1.2% increase in EBITDA margin.
• Enhancing customer experience: 1% improvement results in 1.8% increase in EBITDA margin.
• Optimizing organizational structure and compensation: 1% improvement results in 1.0% increase in EBITDA margin.

By quantifying the impact of each improvement initiative on EBITDA margins, ABC Co. can prioritize resources towards initiatives that offer the highest potential for margin expansion, ensuring strategic alignment with profitability objectives.

Note: Building and utilizing a dynamic operating model requires expertise in financial modeling. While detailed model development is beyond the scope of this article, leveraging sensitivity analysis can provide valuable insights for margin optimization strategies.

As we can see, increasing the percentage of customers who subscribe to the company’s premium software offering increases the EBITDA margin more than any other lever. A 1% increase in sales mix results in a 0.5% increase in EBITDA margin, while increasing customer growth by 1% or decreasing customer acquisition costs by 1% results in only a 0.1% increase in EBITDA margin.

With sensitivities established, the next task is to determine the maximum expected improvement for each of these initiatives. Keep in mind the considerations mentioned earlier: the degree of control and the timeline for implementation. For the sake of simplicity, we’ll assume similar timelines for all potential initiatives, and the likelihood that improvements in one area will help other areas, compounding the effect on margins. (For example, decreased customer churn implies greater customer satisfaction, which can then contribute to reduced customer acquisition costs and lead to increased customer growth.)

Taking revenue per dollar of wages as an example, we can see that a 1% improvement results in a 0.4% margin boost. Some options to increase this metric include:

• Raising subscription prices for new customers while grandfathering in old customers to increase revenue.
• Improving the mix of premium subscription sales to increase revenue.
• Revising the commission structure to align sales incentives with strategic objectives.
• Reducing employee turnover and its associated costs.

There are many other possibilities; the point is that conducting this exercise for each initiative allows management to apply an expected range of outcomes and prioritize its options. ABC Co. produced the following output after establishing the best-case, base-case, and worst-case scenarios for each of its initiatives.

Assuming that these are new initiatives, ABC Co. leadership applied a subjective weight to each scenario, based on their judgment of its likelihood. If you have historical data from prior initiatives, that can also be used to inform the weights assigned to each case.

By calculating the weighted average of each scenario, ABC Co. management was able to come up with an expected EBITDA margin improvement for each initiative it identified. Since we’ve decided that for simplicity’s sake, time and degree of control are nonfactors in this example, the initiatives were then prioritized from the most impactful (premium sales mix) to least impactful (customer growth).

Step 4: Communicate and Implement

After defining and prioritizing profit optimization initiatives, effective communication and implementation are critical for success. Clear communication and resource allocation ensure that the plan is executed efficiently and that employees understand their roles in achieving margin improvement goals.

Key Components to Prioritize:

1. Project Management Hierarchy: Establish a clear project hierarchy to ensure accountability and streamline decision-making. Clearly defined responsibilities help identify bottlenecks and facilitate prompt resolution.
2. Open and Clear Communication: Articulate the project’s strategy and expectations transparently to foster employee buy-in and ownership. Encourage feedback and employee engagement to uncover innovative solutions and address potential challenges proactively.
3. Formal Progress Reviews: Conduct periodic reviews to demonstrate management’s commitment and maintain focus on the initiative. Regular attention from leadership reinforces the importance of margin improvement efforts.
4. Resources and Support: Provide adequate resources and support to enable teams to execute the plan effectively. Be prepared to adapt strategies and implement new processes or tools as needed.

By fostering transparency, providing necessary resources, and maintaining open communication, organizations can equip employees to remain committed and motivated throughout the margin optimization process.

Example Impact: For ABC Co., the expected EBITDA margin improvement from successful implementation of initiatives totals 8.1%, representing a significant increase in profitability. Even achieving half of the stated goals would result in a substantial 4% improvement in EBITDA margin, translating to an additional $1.6 million based on 2023 revenue.

Annual Review and Iterative Process: Integrate profit optimization initiatives into the organization’s annual planning process to keep priorities current and aligned with strategic objectives. This iterative approach allows for multiple rounds of profit optimization until desired targets are achieved.

By adopting this structured approach to profit optimization, organizations can identify and leverage the most effective levers for improving profitability. This extends beyond cost reduction to encompass revenue enhancement and operational efficiencies, enabling agile resource allocation and confident decision-making. Regular progress reviews and strategic adjustments ensure that challenges are addressed promptly, positioning the organization to thrive in any economic environment.

I recommend incorporating profit optimization exercises into annual planning cycles to maintain readiness for economic fluctuations and capitalize on growth opportunities. Whether preparing for downturns or positioning for growth, organizations equipped with a robust profit optimization framework are better positioned to navigate uncertainties and achieve sustainable success.