The Bottom Line: Getting Out of the Weeds

March 1, 2006
By David Shepherd
Step 2 of the “8 Steps Challenge”: Before your firm takes on new tasks to grow profits, be sure it stops the old ones that are killing them.

Last month I introduced the 8 Steps challenge for 2006—a challenge for you to make this a breakout year for your firm in terms of sales and profitability. Step 1, also presented here last month, challenged you to prepare for this new level of success by introducing a culture of change into your organization, no matter how small those first steps might be.

This month I'm going to introduce you to a sophisticated accounting technique ... oh, I'm sorry, did your eyes just glaze over or are you just stifling a yawn? Perhaps I should have phrased that differently. Let me try again.

This month I'm going to introduce you to a simple management philosophy that has helped many clients of mine generate thousands of dollars of additional profit almost overnight. There, is that better?

Before I give you the solution, however, I want to make sure you understand the source of the problem—a problem that is almost certainly taking over your business like hydrilla weed chokes a lake if intervention is not taken. The "weed" choking your business (perhaps under the surface and yet undetected) is complexity, and this is doubly true since you've chosen to compete in one of the most complex businesses I've ever studied. The problem with complexity is that it does not grow linearly; it grows exponentially. It can seem benign one day and suffocating the next.

To make my point, suppose you were given the simple task of photographing two people in all possible combinations as to who is standing next to whom, and who is on the left or right. How many possible combinations are there?

If you said two, go straight to rocket science school. But how many combinations are there if a third person joins the group? How about a fourth? Or an eighth?

The answer to all possible combinations for eight people in a photograph is a counterintuitive 40,320! (If you don't believe me, just grab eight people and try to compose all the different scenarios.) The mathematical solution to this is called a factorial. The solution for two people is expressed as 1 x 2. The solution for eight people is expressed 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8, or 40,320.

This is what I mean by complexity growing exponentially. Now, think of how many individuals and entities interact with your business including employees, clients, suppliers, partners, contractors, accountants, bankers, lawyers, etc. Think of the number of combinations this creates for how many unexpected events and chain reactions can occur in a given day, month, or year—thousands. What drives this complexity to dangerous levels is that most business owners feel a constant and powerful pressure to say "yes." "Yes" to client demands. "Yes" to unreasonable deadlines. "Yes" to almost anything that will generate revenue. "Yes" to revenue at all costs.

The irony is that unless you're a publicly-held company, the top line (total sales) is largely irrelevant while the bottom line (profits and net cash flow) is everything. Can you handle some more irony? The very action of saying "yes" to everybody and everything, while temporarily increasing the top line, is the source of the increase in complexity that almost always eats away at the bottom line.

What has happened over time as you have said yes, is that you have bundled very different types of revenue into one lumpy cloud. You've probably done the same thing with expenses. To calculate a bottom line you've subtracted a big amorphous lump of expenses from a (hopefully) bigger lump of revenues. But by doing this, you're not reporting results, your reporting averages.

What you're giving up is access to the critical knowledge of which expenses directly relate to which sources of revenue. In other words, you're giving up the ability to discern where you're making money and where you're not. You're giving up the opportunity to do more of the former and less of the latter.

If you had access to this information you would almost certainly find that some areas of your business are highly profitable, some marginally profitable and some are money losers.

One firm I worked with was reporting top line sales of about $2 million, but a bottom line profit of only about $100,000. What I discovered after a little homework was that they actually had a design business, a project management business and a procurement business all under one roof. If we called these A, B and C, my investigation uncovered the following:

A was netting $250,000 a year B was losing $100,000 a year Cwas losing $50,000 a year

If this was your firm, what would you do? Sure, it's not always this clean cut, and I realize that A might be somewhat dependent on B and C, but at least we have the knowledge that our net profits could potentially more than double (from $100,000 to $250,000) by doing less. That is, by getting out of those things that are not part of our core competency and that are probably there only because somebody yes one too many times.

So, if you insist on saying "yes," why not say yes to adopting a new management philosophy of matching expenses to the sources of revenue that justify those expenses? By the way, that's the sophisticated accounting technique I mentioned above. It's called ABC—activity-based costing.

I'm not suggesting you get your CPA involved, I'm just suggesting that before you start doing new things designed to grow your bottom line, you should stop doing old things that are killing it. In this case, less really is more.

Next month, I'll introduce Step 3 and I might as well warn you, it's a get-rid-of step as well, only this time we'll be taking the pruning sheers to ... your clients!

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