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Breaking Out of Margin Pressure

John O'Rouke and Karen Dale Torre

Introduction


Businesses across the globe remain mired in the worst trading conditions in more than half a century. The “credit crunch” in 2008 followed by the continuing “Euro crisis” has left many market observers questioning the prospects for jobs, economic recovery, and spending. GDP growth in the Eurozone is on average less than 1 percent and the prospects are not looking good. Moody’s downgraded 16 Spanish and 26 Italian banks, citing the deteriorating economic outlook for Italy and Spain and the reduced credit worthiness of their governments. More than half of Spain’s illuminated highways have had their lights switched partly or fully off, due to recent austerity measures.

But the picture is neither uniform nor all gloomy. Contradictory or regional variations are adding to the complexity of management decision-making, especially the ability to set pricing policy and control margins. US manufacturing is experiencing a rebound and in a sign of growing consumer confidence internet searches for the gold price have fallen by 74 percent from last year’s August peak. (The Economist showed last year that this indicator is inversely correlated with consumer confidence.) The Japanese economy grew by 4.1 percent year on year in Q1 of 2012, driven by strong domestic demand and government spending, and the UK recorded its first quarterly trade surplus in cars and automotive parts since 1976, led by 12 percent growth in exports to countries outside the EU. Emerging economies present significant opportunities—for example, a recent survey showed Nigerians were the fourth-highest spenders in terms of tax-free shopping in the UK in 2011, behind only the Chinese and Russians and shoppers from the Middle East.

However, the overwhelming picture within advanced economies is that consumers (the engine of growth for the last two decades) do not have an appetite for spending. This, coupled with government austerity measures and the price-leveling effect of the internet, leaves companies with very little room for maneuverability when it comes to setting pricing policy. But on the other side of the equation most organizations have cut costs to the bone. This leads to the vexed question: How can companies improve profit margins?

Responding adequately to the challenge of maintaining profit margins requires a deft combination of strategic and operational measures since the two are inextricably linked in the performance management cycle.

The Operational Response to Margin Pressure


The operational response is vested in pragmatic steps concerning the management of working capital, the introduction of profitability management, and activity-based costing (ABC) techniques together with better performance management processes. These measures working in combination can have a profound impact on margin but are often handicapped by poorly developed systems. For instance, profitability management relies on the capture of costs at a detailed level of granularity within ERP systems and activity-based management requires specialized tools. Furthermore, any initiative to improve margins has to be supported by performance management systems that deeply embed appropriate KPIs in performance scorecards and management reporting to ensure that everyone in the organization is strategically aligned. Newer methods of systems deployment such as cloud-computing offer businesses the opportunity to improve margins by better aligning processing costs with the scale of operations.

The Strategic Response to Margin Pressure


The strategic response leverages the insights gained from operational reporting and other sources of information such as industry benchmarks to refine the strategy. For example, profitability management can inform how profits develop over the lifetime of the customer. A better understanding of what drives product, channel, and customer profitability over the lifetime of a customer can lead to better management decisions regarding the ideal customer profile, the attractiveness of different customer segments, and policies around pricing and customer retention. These decisions can in turn be used to inform the creation of more-realistic management objectives and strengthen the accuracy of business forecasts. At a more practical level, this can be managed to a strategic advantage to position new product and service offerings with customer segments at the correct time, leading to improved margins.

Reliable benchmarks embedded in performance reporting inject a degree of objectivity into margin reporting, allowing the organization to position its performance relative to peers or similar organizations and provide external validation to internal assumptions about how well the business is doing.

All of these practical steps, whether strategic or operational, are well within the grasp of most organizations. Times may be tough but with the right management initiatives, methodology, and systems support, there is still plenty of room to improve margins.

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