Increasing operating margins: Four principles you need to know

As consultants with Plante Moran, we’ve been fortunate to work with a variety of clients spanning a number of industries. While there were myriad specific challenges that brought us together, these clients all had one thing in common: they hired us to make them better companies. After all, who doesn’t want to get better at what they do and be more profitable?

The easiest way to make a business more lucrative is to first understand the drivers for top-line revenue (most notably pricing strategies) and analyze margins on a customer, product, and market basis. Here are four principles to keep in mind.

1. Determine if cash flow or profit is your No. 1 goal

You can strategize to maximize profits or cash flow but not both. This may seem counterintuitive — shouldn’t everyone try to maximize profits? Not necessarily. Some organizations prefer to maximize cash flow, particularly those that have limited funding resources or have a desire to return cash to the ownership group. This means that evaluating payment terms, discounts, and collectability is as important as the price. In some cases, getting 98% of your list price in 15 days is preferable to having working capital tied up with customers who pay 100% of your list price but take 90 days to do it.

You can strategize to maximize profits or cash flow but not both.

This principle also extends to vendor strategies. Are you willing to pay more for materials with extended payment terms? This may impact your bottom line through high costs, but getting 120-day terms from one of your top vendors at 5% above the lowest price (at 30-day terms) may allow you to use that working capital for value-generating activities.

Some organizations develop a hybrid approach where a time value of money is inserted into the equation to “optimize” profits. Bottom line: Understand your liquidity situation, and adapt your strategies to that profile.

2. Constantly evaluate available inventory (and lead times)

For this principle, let’s take a page out of the travel industry playbook. The most successful airlines and rental car agencies have sophisticated revenue management systems that constantly update prices based on available inventory and the shelf life of that inventory. Manufacturers can borrow from this approach. Even the most well-run organizations typically have excess inventory — and well-run ones have constant updates to action plans on how to liquidate that inventory, particularly if they’re “running for cash.” Similarly, it may be wise to strategize to realize higher prices when you have limited inventory and long lead times.

Bottom line: No matter what you’re selling, don’t forget the “supply” part of the supply/demand principles.

3. Understand your total costs in layers and the relationship with capacity

It’s critical to understand all of your production/delivery costs and the nature of those costs (fixed versus variable). In addition, knowing the capacity available under different pricing scenarios should be a major driver in your pricing strategies. For example, forcing a fixed cost into the pricing equation often results in quoted prices that aren’t accepted, lower revenues, and underutilized capacity.

While it’s important to have standard cost data for financial reporting and to understand key cost drivers, standard cost should not be the sole determiner of quoted price (for example, standard cost + 10%). In our experience, the biggest mistake that companies make in developing quotes is ignoring the concept of incremental costs and distinguishing those from fixed or sunk costs.

Maximizing returns on heavy investments in capital equipment requires that those machines be kept running. But to keep those machines running, it may make sense to lower your prices for certain products; this may not achieve a break-even point for the product measured against fully absorbed cost, but it may provide an adequate contribution to fixed costs.

Of course, this theme won’t work if your production doesn’t cover your fixed and other costs. Management must fully understand whether the combination of “winner products” and “contributing products” cover all costs and provide the necessary return on investment.

Bottom line: Closely monitoring and analyzing contribution margin to fixed costs is a critical performance measurement.

4. Understand the limitations of “rules of thumb”

It’s typical for a company to shortcut their pricing strategies. For example, some companies may quote based on a labor-hour basis or a dollar-per-machine hour. We believe these rules of thumb are usually a good tool for sanity checking a bid as opposed to a developed quote.

Good pricing is dependent on generating and analyzing underlying data. Best practices at high performance organizations include data-driven principles and discipline in determining quoted prices. Keeping price integrity, understanding your product’s price elasticity, and beating your competition are inherently hard — but they become impossible if you don’t collect and monitor your data.

A good example of using data is developing market segmentation strategies that create new customers at multiple price points. Using market segmentation, a company can ideally capture the lower price market (“bottom fishers”) with a product that’s streamlined, the high-end market (the “luxury buyers”) that includes all features, and everyone in between with a certain price point/utility equation.

Bottom line: Develop the discipline to collect relevant data, and continue to evaluate and react to the implications of that analysis.

In conclusion

Vince Lombardi once said, “Winning is habit. Unfortunately, so is losing.” These four principles are the foundation of a winning organization and the key to increasing operating margins. For more information, give us a call.