Top 3 Sources of Operating Profit Erosion & How To Control Them

By: Andrew Van Breugel, Managing Partner

In managing businesses, we tend to hear a lot about "growing the topline." Sometimes, leaders are fixated on the topline and for good reason; from here flows all possibilities available to the company. Your ability to finance operations, pay staff, invest in the future, and provide a return to owners does, for the most part, stem from your revenue.

In this post, I would like to take a closer look at this from a slightly different angle; the lesser-discussed concept of controlling erosion of operating profit.

What is Operating Profit?

But first, a recap: what is operating profit? Operating profit is what you have left over from revenue before taking away interest expense, and income tax, and ignores any unusual gains and losses that are not considered part of normal operations and might appear down the income statement somewhere. It is sometimes referred to as EBIT (Earnings Before Interest and Tax) and should not be confused with the very much more commonly discussed EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization). So, the difference is simply that EBIT includes depreciation and amortization, while EBITA does not.

EBIT, or operating profit, is meant to be a direct measure of how well a company uses the resources at its disposal and under its control. It is based on the premise that the accounting cost of owning assets is not an operating cost, but an investing cost.

Converting sales into operating profit is the primary function of a for-profit organisation. But do we spend enough effort avoiding the erosion of that hard-earned revenue once the sale is made? Many management teams do not focus strongly enough on controlling the erosion of operating profit. There are three main sources of operating profit erosion

1. Loss from the sales side

2. Excessive product cost

3. Administration and overhead

Erosion from the Sales Side

Close examination of any loss from the sales side in transacting business should be the preoccupation of someone in sales. Look for any rebates, discounts and coupons and make sure you understand why these exist. How do you know that these deductions from revenue are margin accretive to the company? If they are not, why not just sell less? Be especially skeptical of built-in discounts that have just become a part of life.

How often are these reviewed and who has the authority to approve them. Are they specifically called out on sales reports and the income statement? Are the discounts given in arbitrary 'blocks' of say 5% increments? If so, why so? Why not review downwards to blocks of say 3%? Is there a process within the sales function to constantly review why discounts are given and to identify customers who are not really buying because of the discount? Is your sales team incentivized by margin or only revenue?

Excessive Product Cost

Most nearly all products are overpriced to allow for waste, rework, repairs, warranties, or obsolescence. Is lost production specifically accounted for, communicated and visible in reports and in the income statement? Do you know precisely where product waste occurs? Do you have a working list of actions intended to reduce your current waste (assuming you know what it is) by a quantitative margin, say 20% within 12 months? Do you have a working list of actions intended to reduce your warranty and returns (assuming you know what it is) by a quantitative margin, say 20% within 12 months? Do you know the root cause of your defective product, and do you know how much effort is going in to reducing it?

Administration and Overhead

Ok, this one is interesting. I don't mean too many folks in the front office. I am aware of how contentious this topic is. But start with the quality and effectiveness of the information. If we are not willing to talk about overhead, let's at least talk about the accuracy and timeliness of the work they are doing, and specifically the information they manage. Tough to measure, but easy enough to see: errors due to incorrect or poor information, incomplete or untimely decisions. Are you living in the last century still thinking it is best to hold on to those payments for as long as your supplier will tolerate? Yes, you are. And still, you wonder why you get no attention from your supplier and why they spend all their time trying to find other customers. What would happen if you respected their business and treated them the way you would like to be treated by your customers. Maybe not worth a few pennies you save by delaying their payments. At the very least, have you spoken to them about early payment discounts.

Food for thought: The topline is no doubt of vital importance, but let's not allow the erosion of operating profit to be missed. This is in your control and is worthy of a good level of management focus.