MARGIN PERFORMANCE

Dr. Patrick Reinmoeller

Professor of Strategic Management

Cranfield School of Management

Cranfield University

EXPLORING HOW COMPANIES CAN BEAT MARKET EXPECTATIONS

1

Executive summary

In an environment characterized by uncertainty and global competition, margins are threatened like never before and cost optimization is running out of steam. How does margin relate to performance and how can margin be managed strategically?

In fact, little is known about margin management. The interdisciplinary nature of what it takes to move margins has not made it a focal research area in any field, nor an easy target. Based on conversations with C-level executives, and by analyzing the results of a survey of 200 CFOs and CMOs, we find that executives see the importance of margins and how driving margins is linked to outperforming competition and markets.

Yet, how to act is less clear. Providing insight into the current state of margin management, this report distills some surprising findings. It provides orientation on how to overcome the margin gap in practice and what to do about it. Suggestions for taking action are summarized in the Eight Actions Model.

1. Increase awareness of growth driversRaising margins drives growth. Create certainty about what drives your growth by gathering data to challenge your assumptions.

2. Focus on marginSuccessful leaders set priorities; they focus on maintaining or increasing margin. CFOs and CMOs need to devote more time and resources to managing margins. Without their leadership, lower levels in the organization may try but fail in helping the company focus on success.

3. Create a common groundCompanies handle half a dozen different definitions of what margin means. Capture the state of confusion about margin in your boardroom and in your company, visualize it to motivate discussions and develop a shared understanding to finally make margin meaningful.

4. Analyze how to increase marginMany executives at companies that lag behind market expectations do not know how to increase margin. Don’t be one of them. Acquire strategic capabilities. Increase how margin aware your people are. Systematically seize the opportunities that big data1 presents. Address additional data needs. Identify the key levers to manage margins more effectively.

5. Open the data vaultProvide accurate data and insight through systems and reports for larger numbers of employees. Remove data bottlenecks quickly. Identify which employees, aligned to the levers identified above, currently have the strongest need for access to data. Provide them the insight they need to broaden margins.

6. Offer data that mattersUsing a large volume of data can be good, however data quality and data relevance are paramount. The happiness of employees with big data, data analytics and margin management programs depends on the quality of the data. Ensure that employees receive the data quality they need to make better decisions in real-time.

7. Help client facing employees exert better judgmentIt is essential to bring information and intuition together. Enhance employees’ hard and soft skills; help them to rely on their intuition with even greater success.

8. Ensure that awareness, analysis and action are linkedThe ‘triple A’ of awareness, analysis and action need to inform each other. Create positive dynamics for better judgment in the crucial moments when customers make decisions about your company’s margin.

1 Big data is used here as large volumes of structured and unstructured data and application of analytics to unlock its meaning.

2

Margin pressure: More-for-less demand and global rivalry

Many drivers increase pressure on margins across industries: costs are rising and it is harder to charge customers more. Rising uncertainty and fast-paced competition challenge leaders of organizations to hold onto their margins. Non-economic factors including country referendums, extreme weather events, aging societies, and changing demographics in the geopolitical landscape2 increase expenses for most companies and do not help raising prices to equal measure. In fact, increasing health care costs from an aging population with seniors living longer than ever may exacerbate pressure in health and welfare related industries.

Figure 1: Drivers of negative growth (reported by those in organisations that have experienced negative growth)

Economic challenges such as inequality further increase pressure on margins. While inequality between the rich and poor is increasing in many countries, populous emerging economies including China have seen millions lifted out of poverty. This leads to a swelling global middle class whose members start consuming goods that are taken for granted elsewhere. Yet, this surge of the global middle class goes along with a drop of its average disposable income. This increases pressure on companies to localize and respond to sophisticated demand at lower price points. This prospect of having to offer more-for-less across markets aggravates companies’ margin outlook.

Even more daunting is the ease with which emerging market companies have been able to capture significant share in markets that had been thought cornered by incumbents. The increasing number of new rivals in industries, ranging from manufacturing to services to Information Technology (IT) and science, further pressures firms to protect and preserve their margins. Rapid growth of computational power, which rose for decades according to Moore’s law, has contributed to a new kind of industrial revolution3 with great opportunities as well as challenges. Navigating these challenges to harness the potential of digitization and leverage big data is high on the agenda of company leaders as they seek new ways to competitive advantage, even if it is only transient.4 However, the rising pressure to renew strategies frequently requires investments in innovation, skills, talent and IT. All of which add to costs and do not necessarily translate into increased willingness to pay any higher revenues. In response, firms engage in rivalry to capture a larger share of the more-for-less demand with fewer resources.

2 Eurasia Group, 2016.

4 Porter, M.E. (2008) On Competition, Harvard Business School Publishing, Boston, MA; Gunter McGrath, R. (2013) The End of Competitive Advantage: How to Keep your Strategy Moving as Fast as your Business, Harvard Business Press.

3 Brynjolfsson, E. and McAfee, A. (2014), The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. WW Norton & Company.

Price pressure(competitors)

New market entrants

Industry regulation

Debt write-down

M&A activity New market entry / existing

market exit

59%53% 52%

41%33% 28%

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Figure 2: Margin pressures (reported by all respondents)

In 2016 the extreme pressure on margins puts even the largest rise in corporate earnings per share at risk. Not only are markets taken aback by sudden profit warnings, often it is management itself that is surprised at how unexpectedly their companies’ numbers have taken a turn for the worse. How firms can address margin pressure and stay in control of performance is thus a key issue for executives across industries.

Vendavo, a profit and margin optimization solution leader, commissioned a survey of top management (C-level) to better understand the state of margin management. The results allow us to see what the issues are, the gap at the C-level and how margin may be left on the table. This present study reviews what we know about staying in control of margins and builds on the results of this survey of 200 CFOs and CMOs.

There is much academic literature focusing on measures, low cost positioning, incremental improvement and operational effectiveness. For practitioners, cost optimization has become business-as-usual. Yet, profit growth has eluded many a company. Questions about how to create and capture value, and how to drive profit growth, remain unanswered. Some leaders of organizations are skeptical about negative margin developments, sensing that cost optimization has run its course. They understand that they are less in control of what drives shareholder value than is desirable. The results of this report provide pointers to (re)gaining control of margins at the conceptual and practical level.

61% 59%54%

48% 47%

31%

Volatility in costs Rigid internal structures

The margins in our industry are too low to

drive meaningful improvements

Lack of insight into margin and profit

performance

Board or management

strategy to keep margins at a certain level

Unavoidable price erosion over time

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About this research

This research report, written by Dr. Patrick Reinmoeller, Professor of Strategic Management, Cranfield University, focuses on understanding the role of margins in strategy. The study shows the factors that underpin companies’ strengths and weaknesses by examining the strategic role of organizational capabilities in managing margins and ensuring a competitive advantage.

The ideas presented in this paper are based on original research conducted by Dr. Patrick Reinmoeller, who conducted open interviews and held discussions with experts in the field of strategy, including directors from leading multinationals in extraction, manufacturing and services with headquarters mainly based in Europe. Formal and informal conversations have provided insights into the pressures executives face, what holds them back and how they develop solutions.

A quantitative study, which was carried out in partnership with research organization Vanson Bourne and profit and margin optimization solution leaders Vendavo, also informs the ideas presented in this paper. This survey sampled 200 senior company leaders, equally split between CFOs and CMOs and across four geographic areas: the UK and Ireland; Scandinavia; Austria, Germany and Switzerland; and Italy. The CFOs and CMOs responded for companies that had revenue of at least $1.1bn (many were significantly higher) across sectors including chemicals, manufacturing, transport and travel, life sciences, medical equipment, pharma, IT and telecoms, wholesale distribution, construction and engineering, and logistics.

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From hill tops and historic data to real time views of strategy

Strategy did not start with a focus on the bottom line. Inspired by military success, business leaders sought to transfer strategic planning and apply the lessons learned by winning wars. After some initial success in environments that were stable and predictable, strategy moved away from linear strategic planning. Ongoing globalization, especially after China joined the World Trade Organization, advancing digital technologies, greater complexity and uncertainty all blunted strategic planning. The term ‘disruption’ became fashionable in the 1990s and today disruption, a fundamental shift in the product/market and industry, is what executives expect.5 The disruption that killed margins in many industries is the rise of low cost business models, such as Aldi, a discounter, or Ryanair, a budget airline. Operating at lowest costs, yet with positive margins, has become best practice in dethroning incumbents who relied too long on uncontested large margins in spite of their high cost base. Creating such disruptions to gain advantage by surprise and superior cost competitiveness has become part of manoeuvres in strategy.6

From detailing a plan and subsequent implementation directed ‘from a hill top’, strategy has descended to being ‘in the field’, in close contact with customers and competitors, constantly required to adapt to new circumstances. Company results are influenced by many decisions at different levels of the organization. Therefore, companies need the skills to act in real time at all levels of the organization to manage margins successfully.

Upsides: hard and soft skills

Clearly many of these changes have made competition more relentless and reduced margins across many industries. Yet, some of the same changes have allowed companies to improve their game and to seize new opportunities. If we focus on advances in IT (hard skills) and our understanding of the new ‘soft’ skills of leaders, we can see some upsides. IT, including the emergence of the social web, has given companies unprecedented opportunities to generate new, and extract existing, data from multiple sources, internal and external, and even dormant digital archives. Greater computing power and easy-to-use software enhance the level of detail and the speed with which

companies can distil from historic and current data insightful patterns. This provides these companies with an advantage over rivals that understand less well. The best performing CFOs and CMOs use IT to influence how strategies are developed. Larger data sets with structured and unstructured data available in close to real-time allow early adopters of new analytical tools and techniques to turn data into action and get most benefits.7 While such changes may provide competitive advantage now and reward early adopters, they appear to become standard practice and force themselves on laggards.8

8 See also Porter, M.E. 2001 Strategy and the Internet, Harvard Business Review, 79(3); 63-79; Nijholt, J.J., Bezemer, P.J. and Reinmoeller, P. (2016) Following Fashion: Visible Progressiveness and the Social Construction of Firm Value, Strategic Organization, 1476127015617673, first published on December 31, 2015 as doi:10.1177/1476127015617673.

7 E.g. Lavalle, S., Lesser, E., Shockley, R., Hopkins, M.S. and Kruschwitz, N. (2011) Big Data, Analytics and the Path from Insight to Value, MIT Sloan Management Review, Winter, 52(2): 21-31; Davenport, T.H. (2006) Competing on Analytics, Harvard Business Review, January; Davenport, T.H., Barth, P. and Bean, R. (2012) How Big Data is Different, MIT Sloan Management Review, 54(1): 43-46.

6 D’Aveni, R.A. (1999) Strategic Supremacy through Disruption and Dominance, MIT Sloan Management Review, Spring, 127-135.

5 Favaro, K., Karlsson, P.-O., and Neilson, G.L. (2013) Captains of Disruption: The 2012 Global Chief Executive Study, Strategy+Business, 71, Summer.

Figure 3: Tools and skills

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Clearly IT savviness is important, however the skillset leaders need to adapt to these changes is known to be much broader. Intelligence alone is not enough. The new skillset includes broad awareness of context; abilities to frame, gather, analyse the key information; to choose wisely, and to learn and adapt pragmatically. They do not allow leaders to be cognitively, emotionally or socially constricted by their area of expertise or any other comfort zone.

Quest for capabilities

Executives, who recognize that their environment has become much more complex, dynamic and uncertain, acknowledge that new tools, new techniques and a new mind-set are needed. They realize that competences which were helpful in the past, may have lost their usefulness; some of them may even have turned into rigidities or identity traps which hold the company and its people back.

Clearly, building new capabilities is high on the agenda for leaders who seek to deliver results. These new capabilities are needed at the corporate and business unit level to realize the potential of the organization in the near present and in the future. More specifically, companies need capabilities to monitor what is going on, pick up the weak signals, make the right calls and swiftly align resources to seize emerging opportunities or avert threats.9 These organizational capabilities, and the speed by which companies can move

between thinking and doing, and between adding value and taking out costs and managing margins, have become decisive to win in dynamic rivalry.10 Although organizational capabilities to understand what is going on, to figure out what to do and get this done are clearly important, how these translate to specific areas with direct bottom line impact needs further research because companies act through their leaders and employees.

Facing the complexity of today’s business environment and uncertainty about the future, those who lead companies need individual capabilities that allow them to remain aware of the relevant context, draw conclusions from analysis and execute pragmatically.11 Building these capabilities involves becoming aware of one’s own strength but also recognizing hidden bias. CFOs and CMOs who understand ‘self’ better, a precondition for change, can explore how their thinking and behaviour is hindered and, going forward, can help company performance.

11 Reinmoeller, P. (2014) How to win a price war, MIT Sloan Management Review, Spring, 55(3): 15-17.

10 Helfat, C.E. and Peteraf, M.A. (2014) Managerial Cognitive Capabilities and the Microfoundations of Dynamic Capabilities, Strategic Management Journal, DOI: 10.1002/ smj.2247.

9 Teece, D.J. (2007) Explicating Dynamic Capabilities: The Nature and Microfoundations of (Sustainable) Enterprise Performance, Strategic Management Journal, 28: 1319-1350; Eisenhardt, K.M. and Martin, J.A. (2001) Dynamic Capabilities: What are they? Strategic Management Journal, 21: 1105-1121.

Figure 4: Understanding self

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Mind the margin gap

Clearly there are challenges in measuring company performance. Failure to address them can not only lead to unhelpful conformity but it can also hamper creativity that stretches norms of progress.12 Dropping well-established measures and adopting customized accounting measures such as ‘annualized recurring revenue’ or ‘billings’, companies seek to signal good news but may actually be dressing up what is depressing. Even profitability is less facile than one might expect. There are pockets of knowledge about financial measures, means to add value and much about cost optimization, yet little on how these factors influencing margin can be brought to bear.

Focus on measures

Although we know much about financial measures such as profitability or shareholder value, we know much less about managing margins strategically. Analysts may use size, value, profitability and investment patterns to explain average stock returns. Or they use the level of profitability as a proxy for expected future profitability.13 Multiple relationships are known; more profitable firms have more potential for future growth, and firm profitability is linked to future stock returns.14 Higher profitability and higher stock returns in the past predict higher profitability in the future.15 Frequently, profitability is measured with earnings and based on the efficient markets assumption, which suggests that prices are the outcome of rational decisions. Similarly, it is known that in order to raise shareholder value companies have to reduce working capital and/or fixed assets, lower the cost of capital and sell more.

Focus on value dimensions

We find several studies that emphasize different kinds of perceived value that can drive up the willingness to pay. Since the economist, Veblen, in The Theory of the Leisure Class, many authors16 have shown the importance of not only the functionality of goods but also the experience quality of their use, and their social value. These play important roles in enhancing perceived value at the moment of purchase and during use. There is clearly much work on cost optimization. Lean management, business process reengineering, business process outsourcing and many other tools and practices in strategic management focus on cost reduction through operational effectiveness.17 Consider how operational excellence, focused positioning or differentiation can influence margins, yet how these strategies are to be integrated is not clear. What is missing is an indication on how to integrate choices about costs, value added and financial performance to raise profits. Such integration requires strategic judgments in the critical moments.18

14 Haugen, R.A. and Baker, N.L. (1996) Commonality in the Determinants of Expected Stock Returns, Journal of Financial Economics 41 (3): 401–439.

13 Fama, E.F. and French, K.R. (2015) A five-factor asset pricing model, Journal of Financial Economics, 116: 1-22.

12 Shumsky, T. (2016) Companies invent their own performance benchmarks, Wall Street Journal, Updated March 29, 2016 (accessed online); Nijholt et al. (2015) Following Fashion.

15 Cohen, R.B., Gompers, P.A. and Vuolteenaho, T. (2002) Who Underreacts To Cash-Flow News? Evidence from Trading Between Individuals and Institutions. Journal of Financial Economics 66 (2–3): 409–462.

18 Nonaka, I. and Takeuchi, H. (2011) The Wise Leader, Harvard Business Review, May (accessed online).

17 Porter, M.E. (1990) What is strategy? Harvard Business Review, 74, 6: 61–78; Rigby, D. and Bilodeau, B. (2015) Management Tool & Trends, Bain & Company.

16 LaSalle, D. and Britton, T.A. (2003) Priceless: Turning Ordinary Products into Extraordinary Experience, Boston: Harvard Business School Press; Eisenman, M. (2012) Understanding Aesthetic Innovation in the Context of Technological Evolution, Academy of Management Review, 38(3): 332-351.

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Trade-off and judgment

Seminal work on important generic strategies, including differentiation and cost leadership, emphasizes the need to make trade-offs.19 Such trade-offs can be essential to strategies of companies, yet where customers demand combinations, e.g. value for money, strategists need to carefully understand how this influences their profit margins. Therefore, how to raise prices and lower costs when facing a customer requires more research. In spite of insightful work done in the area, profit margins are often taken as a dependent variable of more general factors such as the structure of markets, competitor environment, the profits made in an industry, a company’s resources or opportunity costs. Although we know that a corporation’s profit margins are influenced by the relative strength of its capabilities, we also know how strategic decisions for diversification can trade off profit margins in favor of growth.20 Understanding what influences the average return to capital across the multiple businesses within a corporation may not help with business unit specific decisions or the margin impact of judgment.

Knowing how to power margin

General patterns do not help to understand how companies can drive profitability by managing their margin. How to increase profit margins, how to sustain elevated margins, which decisions interact to influence margins, and how or why small firms accept low profitability remains unclear.21 Consider that pioneering Rolls-Royce started speaking about ‘Power by the Hour’ more than thirty years ago to capture higher profits by emphasizing services. Long term contractual agreements about performance-based logistics predefine rights and obligations and lock companies into price levels, while the developments of the costs cannot be known. This leaves the margin at risk. Although there is evidence that more frequently scheduled maintenance and better care performed during each maintenance event can lead to higher product reliability,22 early adopters of this approach to higher margin found themselves suffering insufficiently realistic risk assessments of possible adverse margin developments. As this example shows, while assessing margins in a moment is hard, seeking to optimize margins into the future with a signature of a long term performance-based contract is harder. To sum, there is not much evidence on how to manage margins strategically by adapting in a changing environment. This is the core of what follows.

19 Porter, M. E. (1996) What Is Strategy? Harvard Business Review, 74, 6: 61–78.20 Levinthal, D.A. and Wu, B. (2010) Opportunity Costs and Non-Scale Free Capabilities:

Profit Maximization, Corporate Scope and Profit Margins, Strategic Management Journal, 31: 780-801.

21 Fama, E.F. and French, K.R. (2015) A five-factor asset pricing model, Journal of Financial Economics, 116: 1-22.

22 Guajardo, J.A., Cohen, M.A., Kim, S.-H. and Netessine, S. (2012) Imact of Performance-Based Contracting on Product Reliability: An Empirical Analysis, Management Science, 58(5):961-979.

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CFO and CMO perspectives on margin, performance and Challenges

In this section we reflect on the insights gained from the Vendavo survey and the numerous discussions we have had with experts in the field of strategy and strategy practitioners. In particular, we discuss why margin has come to play an important role in leading companies to success.

Importance of margins

More attention needs to be paid to margin. Company leaders across industries, but particularly in logistics, distribution, IT/telecoms and health, see margin improvements as very important. Often their executive team talks about ‘keeping an eye on the margin’, or ‘clawing our margin back’. What are better ways to manage margin? Clear priorities emerge. Cost cutting appears to be strongly routinized. When asked what to do, the immediate reaction is often ‘cutting cost, of course.’ Increasing revenue and driving incremental improvements in margins are among the top priorities for the CFOs and CMOs. Incremental improvements in margins is a top priority for many. CMOs see more potential for such improvement than CFOs. Their professional orientation is clearly recognizable as CFOs are more concerned with earnings per share and CMOs with increasing revenue. Taking the customer perspective allows for thinking about how to improve margins by raising the willingness to pay. One CEO explained: ‘I make a point of visiting stores and talking with customers and our supply chain partners directly. I always learn something I can improve.’ In contrast, taking the perspective of financial markets offers fewer opportunities to make meaningful improvements for customers. The focus quickly returns to costs.

However, CFOs and CMOs agree on the importance of driving incremental improvements in margins and sustainable profitable growth. For most respondents, margin is important, and for a clear majority it is very important to maintain or increase margin. Executives are concerned about decreasing margins and share: ‘It is a constant battle for us.’ Recently, a senior executive commented on the challenges of the relationship with his major client: ‘Every year the prices they offer come down. They take efficiency gains for granted, if we achieve them or not. They base their new prices on what they expect. This squeezes our margin every year, for years. And we see no end to it.’

Figure 5: Importance of margins (reported by all respondents)

30%

54%

14%

2% 2%

41%

51%

8%

0% 0%

33%

52%

10%3% 2%

4%

61%

28%

2%4%

Total Ahead of market growth expectations

Aligned to market growth expectations

Behind market growth expectations

Vitally important Very important Quite important Not very important Not at all important

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Key factors that influence companies’ ability to maintain and improve margins.

Three kinds of factors matter: external, internal and cognitive factors. Competitive pressures, volatility, price erosion and weak demand in mature markets emerge as key external factors that lie outside of any company’s control. The challenges differ. Compare a CEO in the pharmaceutical industry’s explanation: ‘We face erosion but we also face the patent cliff. As soon as our patents expire, our entire profit and volume is at risk. Well, it is almost certain that a generics enters and alters the game.’ The fundamental challenge remains similar. Erosion of margins through, for example, legislative change is well known across industries.

Internal factors matter most

The prominence of internal factors is striking; these include rigid internal structures, lack of insight into margin and profit performance, limited communication between units, a paucity of tools, data and business intelligence. Especially, experienced (and older) CFOs and CMOs (55 years old and older) see the internal rigidity as key culprit. Although the context is challenging, many main challenges lie within or can be influenced, including supply chain complexity and maturity of markets. Resignation into a mindset that nothing can be done and that the margins are too low to drive meaningful improvements is unfortunately common.

CFO and CMO are alike in why they differ

While the views of CFOs and CMOs are highly consistent there are two noteworthy differences. True to type, CFOs are more acutely aware of the rigid internal structures, which appear to impede their access to the data when they need it and how they need it. CMOs lament, even more than the CFOs, the general lack of insight into margin and profit performance. Such lack of insight is acutely felt in manufacturing, chemicals and wholesale distribution, whereas resignation is most strongly present in IT/telecoms and life sciences/medical equipment/pharma. One executive summarized as follows: ‘The markets are fast changing; it is us who are too slow adapting.’

Satisfaction with margin systems explains company performance

For listed companies the pressure from markets is high. Those companies that meet or exceed expectations of analysts clearly perform at highest levels. Of all companies covered by the research, 58% have experienced negative growth during the last five years with an average of 1.39% negative growth per annum. There is a clear view of what has driven negative growth: competitive price pressures are clearly number one, especially in the life sciences, medical equipment, pharmaceuticals23 and logistics. New market entrants and industry regulation are the next two most important drivers.

Excellent performance comes with better margin management

Many CFOs saw their companies gain shareholder value (as measured in earnings per share) during their tenure by an average of 4.8% or higher in chemicals, wholesale distribution and IT/telecoms (compared to construction and engineering with 1.62%). There is a strong relationship between such companies and their satisfaction with programs for margin performance. Of the 200 CFOs and CMOs surveyed, 24% admit their performance is slightly or significantly behind market expectations. More than 65% that meet or exceed market expectations are satisfied with and rely on the programs for margin performance. Companies that are happy with the programs in place to manage margins beat the markets’ growth expectations. These programs do what they are expected to do and their quality is strongly correlated with superior performance.

23 Please note the life sciences/medical equipment/pharma finding is based upon a low base size.

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Caught in Clarity

Strategists may seek clear solutions and subscribe to the idea that decision making is about clear trade-offs, and less about finding new solutions. With the idea of clear trade-offs in mind, strategists make reasonable choices to secure the success of a company. They may consider generic strategies, among which low cost positions are prominent. The clarity of such choices enables the implementation of the low cost strategy. Such strategies’ focus and coordination allow for ‘reducing costs’, ‘taking costs out’ and ‘bringing head count back’ and they may produce results in the short term. While clarity and simplicity allows for a focus on costs, opportunities to manage margins more comprehensively may be lost. ‘We wanted to improve our margin by focusing mainly on costs,’ explained one CMO, ‘We did this for years…and only saw our margin come down. We did not look at what our efforts did to perceptions of customers.’

Figure 6: Simply silos

Reverting to type

Many people are involved in the implementation of strategy. After successful careers largely within silos, sometimes within a single organization, newly appointed leaders of organizations face complex problems and great uncertainty for the first time. This challenge renders effective decision making difficult and it requires capabilities that allow for making the right choices. Those who rose through a functional discipline are likely to fall back to seek tools and solutions from that discipline. They revert to type. Also leaders of companies tend to revert to type when they are confronted with such a challenge. Leaders with an operations background may focus on efficiencies and reducing costs. Others with a sales background may focus on promotions to gain market share. Their approaches to implementation will rely on (re)employing the tools and techniques that have been useful in the past. This effectively exploits what people know and can do well, yet it leaves opportunities that reside in learning and in cross-functional collaboration unexplored.

Importance of simplifying not too much

The clarity of strategic thinking is necessary for alignment, however if this clarity involves oversimplifications it limits leaders and their organizations in finding better ways to manage margins. Similarly, constraints on a strategy based on functionally rooted thinking do not allow for more complex strategies that involve pursuing lower costs and higher price points at the same time. Exploiting current knowledge and routines can limit exploration and learning.24 Yet, Apple illustrates that a low cost position does not force low price strategies. While integrating exploration and exploitation may introduce some complexity, it allows for more than cutting costs, it can help manage margin increase.

24 O’Reilly, C. A. and Tushman, M.L. (2013) Organizational Ambidexterity: Past, Present and Future, Academy of Management Perspectives, 27(4): 324-338.

12

Margin control: how to drive growth

Executives are concerned about margins because they know they are important. They know about the close link between driving margins and outperforming competition and markets. Given these results, five surprising findings provide deeper insights into the gap of margin management in practice and what to do about it. They focus on the main challenges, definitions, knowledge of what to do, knowing what the sales team does, and key tools.

The challenges: external and internal threats and ability erosion

Many challenges threaten margins. Competitors, new and old, fluctuations in markets, raw material costs, weak demand, maturity of markets, cost of sale, and difficulty to identify new growth opportunities undermine company efforts. Major political events, including the UK’s vote to leave the European Union, also have the potential to trigger wider economic uncertainty and threaten margin. Among these many are external and outside of the control of management. Yet, the cost of sale as well as the ability to identify new opportunities for growth may well be within the remit of what company leadership can choose to address. There are seven main challenges: supply chain complexity, inadequate tools, limited access to data (e.g. on cost or performance), inefficient or outdated processes or systems, lack of communication between teams, raw material costs and sub-optimal resource management. Most of these challenges can erode companies’ abilities to maintain their margins. They are all internal causes; executives can address each of these challenges and strengthen their company’s ability to increase margins. Self-afflicted challenges are most unfortunate, yet, fortunately they can be addressed effectively.

Figure 7: Challenges to improving margin (reported by all respondents)

Supply chain complexity

Inadequate management tools to manage profitability or manage deals

Access to data; cost, performance, etc.

Inefficient or outdated (perceived) processes or systems

Lack of communication between teams

Raw material costs

Sub-optimal resource management

Underperforming sales force

Unreliable sales forecasting

Limited intelligence on current or potential customers

Lack of alignment of global divisions

Defecting customers

There are no challenges

31%

31%

29%

29%

27%

25%

25%

23%

20%

19%

17%

14%

4%

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Definitions: more than words – alignment through shared meaning

Margins are important to CFOs and CMOs. Yet, not all companies have clear definitions of what they mean with ‘margin’ when they use the term internally. ‘Every unit seems to have its own definition,’ suggested a CEO. This may explain the lack of communication between units and lack of alignment between units of large corporations. Without a clear definition of margin, it is likely that companies do not focus on what drives growth. For 57% of the CFOs and CMOs, definitions of margins in their companies are often open to interpretation across different areas of the business or regions; 18% do not have any agreed consistent definition of margin and 5% are not sure whether there is such a definition. The average number of definitions of margin, as estimated by the CFOs and CMOs is seven, while 14% of the organizations have between 11 and 20 definitions. A minority, mainly in sectors such as manufacturing, chemicals and wholesale distribution, report between 21 and 30 definitions. Such a lack of consistent definitions that are used within the companies hampers these companies’ abilities to drive growth.

Given the limitations in consistency, the lack of strength in measuring margin at 39% of the companies is no surprise. Alignment without commonly shared definitions is elusive because companies lack the foundations for organizational excellence. Without a common language companies are forced to muddle through a lack of common understanding, coordination across units, focused action and shared insights. Consistent definitions are mostly found at companies that are ahead of market expectations; at companies that lag behind growth expectations the lack of any agreed consistent definition of margin is conspicuous.

Evidently, the level of satisfaction with margin management systems appears related to sharing a common understanding of what margin means. The lack of definitions is associated with disappointment in the system. This shows how having a system helps, yet having a system without a common definition may not be enough. Without a common language, views and shared meaning that align people in exploiting the power of such systems, the benefits remain below potential. CFOs and CMOs report that the accuracy and insight gained from margin performance systems enhances their ability to measure deal profitability and their confidence in developing aggressive growth plans. ‘We asked for facilitation to get this out of the way. We had to make sure we know what each of us means when we are talking with each other. It was the best investment in ‘infrastructure’ we made so far.’

Figure 8: Consistency of definitions and satisfaction with margin systems (reported by all respondents)

Yes, there is one completely consistent definition used everywhere

Yes, to an extent, although this definition is often open to interpretation across different areas of the business or regions

No, we don’t have any agreed consistent definition of margin

Unsure

Happy with accuracy and insight of margin systems

Unhappy/neutral with accuracy and insight of margin systems

31%

64%

48%

36%

10%4% 1%

6%

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Knowing what to do: cut, create and shape

Executives at many companies did not know what to do to drive margins. Surprisingly, of all CFOs and CMOs, 38% were unsure or did not know what to do to increase margins in their business tomorrow. Smaller companies (between $5.1bn and $10bn) stand out with 49% of the executives feeling uncertain. After years of cost optimization, they may have simply reached a point where they see decreasing returns of repeating the same approach. One CEO confided: ‘We have done it; we have done it so many times. We just need to find a better way.’

Figure 9: Not knowing what to do (reported by all respondents)

Excellence goes along with effectiveness

The difference between growth companies that defy expectations and those that cannot meet them is clear. Companies unable to meet growth expectations have executives that are unsure about what to do to increase margin. Those leading companies that outperform their peers know what to do, how to do it, and they are confident to do so. When looking at those who know what to do, this study shows three ways to increase margin; cutting costs, creating and shaping.

Cutting costs: Reducing IT costs is mentioned by more than 60% of those who know what to do. Other areas to address are of course not exempt. Clearly, also increasing volume can help to reduce costs. For companies in life sciences, wholesale distribution and travel and transport, reducing IT costs was a clear way to address margin increases. Workforce redeployment (e.g. outsourcing) seemed more important to CFOs and in the Nordic region.

Creating value: Ways that add value to customers and allow moving the price point north include extending product cycles and increasing pressure on sales teams to improve margin. Industries such as life sciences and IT/telecoms emphasized increasing the productivity of sales teams.

Shaping margins: Acknowledging some variation across regions and industries, we find that those who know what to do have a clear understanding of how they can shape their margins by reducing costs and raising their price point.

Knowing what the salesforce does

Sales teams make their pricing decisions relying on gut feel – more often than needed. Although the majority of CFOs and CMOs are happy (57%) with the accuracy and insight provided by the companies’ systems and programs for margin performance, with CMOs being particularly pleased (65% are happy), the use sales teams make of these programs is sobering. Only 30% report that their sales teams base their pricing decisions on up-to-the-minute data at their fingertips. Looking into what sales teams rely on when they make their crucial pricing decisions, we find that the relationships with

62% 73% 67%33%

19%

19%

13%

15%17%

16%35%

33%

Total Ahead of market growth expectations

Aligned to market growth expectations

Behind market growth expectations

Yes. Would know what to address No. Would not know what to address Unsure

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customers, recent prices in similar deals and gut feeling are most important across all firms. When we compare the companies that beat growth expectations with those that do not, one pattern is clear. Companies that disappoint market expectations rely most on gut feeling and prior relationships while disregarding real-time data, yet companies that beat expectations rely on enhancing client relationships with up-to-the-minute data to allow for better judgment.

The ability to use up-to-the-minute data is clearly linked to companies’ ability to drive growth in margin and beat market growth expectations. After explaining how his CIO wants data, systems and routines, and his sales leader wants experience, one company founder emphasized: ‘We want them to use their gut feel, their experience and intuition after they have consulted the facts – not before or instead of accurate and timely information.’

Figure 10: Sales force pricing decisions and shareholder value (reported by all CFO respondents)

More collaboration, better insight and stronger teams: the tools it takes

Driving margin requires both tools and ability. Although margins and margin management are seen as very important, less than a fifth consider their ability to be strong enough to drive significant year-on-year improvements in margins. Of all responding companies, 96% report to perceive clear challenges to their ability to improve margins.

The emerging list of what assails their ability to drive growth is telling. Close to half of the respondents consider their abilities to drive margin improvements as not strong. While delivery, product management, pre-sales and after sales support are seen as mostly lacking understanding, three organizational functions – marketing, sales and finance – are seen to best understand how to effect margins. These functions also know their tools that may work. CFOs and CMOs ask for performance tools that provide better insight into margin performance. In line with this, real-time dashboards and a talented sales force to close deals at higher margin indicate that well-known tools are clearly important. However, the top two tools are more collaboration across the business and better insight into margin performance. Collaboration and stronger teams show how important people, and their ways of doing things, are in efforts to raise margins. Although dashboards and sales force are important, CFOs and CMOs are advised to also change perspectives and look into how people can gain better insight and how they can collaborate better.

80%

62% 66%

28%10%

33%45%

28% 29%

71%

39% 45%

Low gains for shareholders (CFO only) Moderate gains for shareholders (CFO only) High gains for shareholders (CFO only)

Gut feeling/judgement

Relationship with customer

Recent prices in similar deals

Up-to-the-minute data at their fingertips

80%

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Figure 11: Tools to manage margins (reported by all respondents)

Figure 12: Sales force decision making, margin management abilities and shareholder value (reported by all respondents)

More collaboration across the business

Better insight into market performance

A stronger team A real-time dashboard

Sales force to close deals at a higher margin

Unsure

61% 59%55%

41%36%

1%

44%

32%

40% 42%

16%

27%23%

8%

29%

37%

48%55%

Low ability(1–6 rating)

Moderate ability(7–8 rating)

High ability(9–10 rating)

Behind market growth

expectations

Aligned to market growth expectations

Ahead of market growth expectations

Total Sales team base decisions on the up-to-the-minute data at their fingertips

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Margin drivers: what CFOs and CMOs learned

Most effective: seven levers

In the last five years, most companies actively worked to respond to threats and challenges to influence profit. The majority of companies worked on strategic programs to reduce costs and increase efficiency, which had a business unit or corporate focus. Where industries like transport and travel and life sciences/medical equipment/pharma have employed this lever much, others such as manufacturing and chemicals seem less active. About half of the companies worked on pricing, i.e. increasing or decreasing prices in specific product-markets. Out of seven profit levers, three others were more remote from operations, i.e. actions shaping the scope of corporations. Companies sought to influence profitability through mergers and acquisitions, division sell offs and market exit. Finally, two levers, short-term derivative trading and currency trading are even further remote from operations.

For all companies that sought to influence profits in the past five years in different ways, two stand out. First, strategic efficiency programs and cost reduction programs have been very popular across companies, especially among those disappointed with their results. This popularity may indeed limit these programs’ ability to provide a competitive advantage for any company because each is seeking operational effectiveness in very similar ways. With the repeated application of such programs – often under different labels – companies are reaching a limit. With negative and unintended consequences like job uncertainty and demotivation among employees on the rise, the decreasing returns of expensive cost reduction programs no longer justify their repeated application. As one company leader put it: ‘Cutting any further does not make sense.’

Second, the more successful companies found ways to make smarter pricing decisions. Clearly more demanding than taking out costs, smarter pricing decisions are more information intensive and require more intelligence because they can only be based on a firm grasp of the relationship with customers. However, these more resource intensive pricing decisions allow companies to optimize margins in accordance with changes in the environment. If managed to remain legitimate in the eyes of the customer, smart pricing provides more opportunities more sustainably.

Besides the above there were other ways to influence profits. For larger firms in particular this included mergers and acquisitions, business exits and division sell-offs. All companies found M&A and division sell-offs to be least effective. Corporate objectives for these moves were not fully achieved for more than 40% of the companies, which compares unfavorably with the high expectations most companies had for achieving or out-performing their objectives.

Reason for profit levers

Companies can react to events or they can take strategic action, where careful anticipation of developments allows making choices that can influence events. Research shows how companies can beat market expectations by increasing the motivation to apply profit levers. A clear pattern shows the more successful companies deploy profit levers as part of a long term strategy or a new strategy. At times they deploy profit levers as a reaction to competitor actions. The firms that lag behind market growth expectations mostly react to national and global economic events, competitor actions, and industry events.

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Looking ahead

After reviewing what is known about margin management, we found three explanations for the paucity of knowledge. One, margin sits between the fields of strategy, finance, accounting, marketing and sales and has not benefited from concentrated research efforts. While each field touches upon it, none has made it a focal area of analysis. Two, each area addresses topics adjacent to margin and applies much rigor. The choice to focus, for example, on lowering costs and committing to this approach became somehow tied to mass production and low margins, while the choice to differentiate came to be linked to smaller lot sizes and higher margins. This is helpful, yet it has not allowed for exploration of what only recently has gathered attention; hybrid strategies seek reconciliation of paradox.25 Revisiting contradictions and trade-offs, strong and weak, opens up the opportunity to understand how margins can be managed better. Raising prices/reducing costs and reducing prices/raising costs reveals contradictions that practitioners face frequently. This study offers first observations and sense making. Three, hard and soft skills have changed what is possible. Making the right decision at the right time with up-to-the-minute information may have seemed like fantasy decades ago. Today reconciling contradictions is already facilitated by IT, big data and analytics, and margin management programs that provide reliable evidence to better inform judgment by experienced managers - just in time for when they face their customers. Leveraging the advanced technology available now, embracing data volume, data richness and algorithms to develop and test ideas appears a promising path to bolster the performance of both CFO and CMO by advancing the company’s fortunes.

25 Smith, W. K. And Lewis, M.W. (2011) Toward a Theory of Paradox: A Dynamic Equilibrium Model of Organizing, Academy of Management Review, 36(2): 381-403.

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Eight actions model

This study provides clear pointers to how companies can regain control of margins not only at the conceptual but importantly at the practical level.

Figure 13: Eight Actions Model

1. Increase awareness of growth drivers

Raising margins drives growth. CFOs and CMOs at growth companies that raise their margins year-on-year are more likely to report that their organizations outperform market expectations (31% compared to 16%). Create certainty about what drives your growth by gathering data to challenge your assumptions.

2. Focus on margin

Leaders set priorities. Company leaders who see their companies growing faster than market expectations report that their growth companies are more focused on margins. For these companies, 41% of the respondents emphasize that maintaining or increasing margin is vitally important, compared to only 30% in all companies. CFOs and CMOs need to devote more time and resources to managing margins. Without their leadership, lower levels in the organization may try but fail in helping the company focus on success.

3. Create a common ground

Surprisingly, companies handle on average seven different definitions of what margin means. These differences give rise to misunderstandings and misalignment and prevent an effective focus on margin. What is needed is clear language, a shared view and meaning of what margin is and how it is achieved and can drive growth. Capture the state of confusion about margin in your board room and in your company, visualize it to motivate discussions and develop a shared understanding to finally make margin meaningful.

Improve judgement

Triple A

Open the data vault

Offer real-time data that matters

Exceeding growth expectations

Awareness of growth drivers

Focus on marginCreate a common

groundAnalyze how to increase margin

Managing margins

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4. Analyze how to increase margin

While executives of companies that lag behind expectations frequently do not know what to do or how to increase margin, leaders at growth companies actively manage margins. They have experienced working with different tools and used different profit levers. Unfortunately, their focus and their experience in the last five years has been biased towards cost cutting. Going forward, company executives need to acquire strategic capabilities that allow them to expand margins by reducing costs and raising prices by creating value. Increase how mindful people are about what influences margin; organize customer encounters, field trips and ‘pauper’ experiences to raise employees’ awareness. Rigorously analyze the large volume of structured and unstructured data already available to identify the key levers of margin after addressing additional data needs.

5. Open the data vault

Provide accurate data and insight through systems and reports for larger numbers of employees. Opening access to data is similar to smart altruism, the giver will be given. At growth companies, more than 75% of the respondents are happy with the accuracy and insight provided by systems and reports meant to help with margin management. The strong association with data quality, user satisfaction and ability to grow business through margin management, clearly needs further research and clarification. Yet, providing intuitive tools that offer those making the critical judgments with better insights appears to be important in raising the level of how organizational knowledge is created and deployed. Remove the bottlenecks quickly. Identify which employees, aligned to the levers identified above, currently have the strongest need for access to data. Provide them the insight they need to broaden margins.

6. Offer data that matters

While large volumes of data can be good, its relevance is paramount. When sales teams make decisions they are engaging with customers, often long standing relationships, and they rely on gut feeling because often not much evidence is available. As the study shows, supporting decision makers at all levels to exert better judgment based on better data, that is accurate, timely and specific is a great opportunity all companies can seize. Happiness of employees with big data, data analytics and margin management programs depends on the quality of the data. Ensure that employees receive the data quality they need to make better decisions in real-time.

7. Help client facing employees exert better judgment

It is essential to link information and intuition. The study shows how important changing the scope of corporations is to influence margins together. However, it is also clear that the high availability of more abstract KPIs could support corporate decisions that carry a high risk but it could also nudge decision makers to consider these high risk options more. The further we approach individual clients, specific product-market combinations and take client relationships into account, relevant data becomes progressively scarce. Many organizations suffer the lack of language, tools and skills leaving gut feel and the status quo as the only points of reference. Better judgment needs overview, parameters and grasp of detail over time. Shedding more light on the facts at the level of detail needed for negotiations and client interaction requires a common language, understanding and desire to raise the game. Enhance hard and soft skill of employees; they help them to rely on their intuition with even greater success.

8. Ensure that awareness, analysis and action are linked

Awareness, analysis or action are not enough alone. Providing data alone without meaning, offering analytical results without guidance on alternative options to take is not helpful. Continuing and letting gut guide action is equally unwise. Awareness, analysis and action (Triple A) need to inform each other. This requires creating overlaps, sequences and loops; continuous spiraling generates better judgment in the crucial moments when customers make a decision about your company`s margin.

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The eight actions require imagination and commitment. If a company is to take control of its margin, its leaders need to reconcile contradictions internally and overcome barriers to data, communication and collaboration. Empowering people across the company with tools that are fit-for-purpose and abilities to access data in real-time enhances relationships with clients by providing more value at higher margins. It is not fantasy to accurately measure and report profit and margin up-to-the-minute. Companies that are already investing in such real-time solutions are outperforming their competitors with healthy margins and sustaining leading positions in their chosen markets. Ambitious CMOs and CFOs with their minds set to raising profits are best positioned to significantly create and shape margin performance to increase shareholder value.

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About Vendavo

Vendavo harnesses the power of Big Data to generate actionable insights that enable businesses to sell more profitably. Our margin and profit optimization solutions help global customers make better data-driven decisions for pricing and sales effectiveness. Using cutting-edge analytics and deep industry expertise, Vendavo boasts the largest number of implementations for B2B enterprises in the industry, having helped more than 300 company divisions dramatically increase revenue, improve profit margins and maximize shareholder value. Located across the globe, Vendavo is the solution of choice for Global 2000 companies in industries such as chemicals, industrial manufacturing, high-tech, and distribution.

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