Profitability at the expense of Growth?

Apart from the clichéd ‘shareholder value creation’, all private enterprises have precisely ONE objective: profitable growth, i.e., top- and bottom-line growth. Indeed, hard, liquid profits speak like no other metric. But profitability and growth is not the same thing. The relationship is a complex, multi-layered one.

Top-line growth may provide an organization with scale, particularly if its cost base has a large fixed component, thereby allowing economies of scale and increased profitability. The steel industry, for example, requires massive investments in plants and equipment. Expenses incurred to finance these are amortized across say, every ton of steel produced. As the company grows (measured by number of tones of steel produced), the per-ton fixed cost allocated reduces, resulting in increased per-ton profitability. Conversely, blind growth with massive infusions of capital (presumably with a strategic long-term angle) can have the opposite effect on short and mid-term profitability.

Strong profitability itself can provide the company with more capital, thereby financing growth and in an ideal world, creating the kind of positive-loop that C-level managers dream about. But as Fred Reichheld, Bain & Co’s first Fellow says, ‘Bad Profits’ do exactly the opposite. They stagnate and even reverse growth, demoralize employees and eventually concede market share to the competition. ‘Bad profits’ are earned when companies pursue profits at the expense of customer relationships.

Management guru, Peter F Drucker, famously said that a company must define itself not by the product or service it provides but by the value it creates for its customers. Bad profits do the opposite; they seek to extract the maximum possible value from each customer. Indeed, there are certain industries where the practice is endemic. Think of the Airlines industry. You cancel a ticket 24 hours before your flight and outrageous cancellation charges are levied. Why? The overhead for the airline to carry out the cancellation is minimal. As for lost revenues, studies show airlines are unable to find new customers for cancelled tickets on only 3% of such occasions. The average cancellation charge for all airlines worldwide: 21%!

Southwest Airlines in the US today has a market capitalization that is greater than all other American airlines combined, driven by a relentless pursuit of what I call “good profits”. Rather than levy a cancellation charge, they delighted their customers by allowing them to carry forward paid credit for a period of one year on any route. I know I prefer flying SpiceJet in India precisely for this practice of theirs.

Why then, do organizations continue to follow such practices? Part of the trouble is that traditional accounting practices have no means of differentiating between good and bad profits. Revenues earned from ruthless penalties look exactly the same on the Income statement as revenues earned from the healthier repeat purchases. ‘Customer discontent’ finds no place in the Balance Sheet Liabilities.

While nearly every CEO recognizes the importance of building strong customer relationships, mid-level management is nearly exclusively judged on profit generation, however that may eventuate. This results in an inherent mis-match between stated objectives and incentives to perform. Indeed, mid-level management can’t be blamed for focusing on the parameters on which their performance is judged.

No accountability, no delivery they say. And accountability requires hard, objective metrics of measurement. Profit measurement is refined to a science today: Gross Margin, EBITDA, Net Income, et al. And so are mid-management measured.

But customer satisfaction? Hmm, let see….repeat purchase percentage is one touted metric. But who knows if a customer is coming back because he truly likes your service, or because he is just plain lazy or indeed temporarily has no other choice? C-SAT surveys, another oft-used practice offers little more than conjecture since they do not relate to how a customer will truly behave.

There are other surrogates around. The ‘Net Promoter Score’ which is essentially the percentage of your customers who are your ‘detractors’ subtracted from the percentage who are active ‘promoters’. Simple enough conceptually, but I’m a little worried that the Garbage-In-Garbage-Out syndrome may apply here: the feasibility of accumulating accurate input data is questionable.

As long as customer satisfaction/loyalty remains objectively immeasurable, management will not be made directly accountable. And cases such as AOL and Delta Airlines, big pioneering companies that have fallen by the wayside due to a failure to differentiate between good and bad profits will continue to occur.