The O'Connor Group is fortunate to have a unique perspective on the business world. Our clients come in all sizes, from all industries, and range from well-run companies needing interim management skills to struggling companies in need of a major fix. One area that many companies struggle with, regardless of their success, is their ability (and sometimes willingness) to measure the quality of their revenue across the spectrum of products, services, customers, etc.

What is Quality of Revenue?

Each dollar of revenue is not equal. Some products/services are more profitable than others. The same is true for certain customers, business lines, and locations. This is true for every company, but a key difference is that Home Depot can calculate its profits for every hammer it sells; the local hardware store may only have a general idea. The same is true for many middle market companies. It can be difficult to determine which streams of revenue to increase, decrease, or try to improve.

Obviously, companies try to make money on each product/service offered. In reality, some make money, others do not, yet managers often fail to either recognize lackluster results, or justify their existence as a means of absorbing costs. Absorption is often used to justify bad business decisions. It measures a product's ability to absorb fixed costs (i.e. overhead) on a per-unit basis. A simplistic example would be a manufacturer renting a factory for $10k/mo. The rental cost per unit changes as production changes, as follows:

When production levels go down, the impact of rental expense increases dramatically – management teams easily understand this. When revenue falls, the chart above points to a simple solution –increase revenue. Two problems with this are a) increasing revenue is very difficult, and b) it can cause more harm than good.

When revenue declines, absorption becomes a hot topic. Most companies consistently try to grow revenue – it is naturally associated with financial health. Further, many divisions of a company are inclined to see revenue growth as a goal, rather than as a means to generating greater profits. Higher production levels allow companies to operate more efficiently, and increases job security. When the top line grows, commissions (and job security) increase. Obviously, both of these groups should have their interests aligned with profitability, because failure to do so can have disastrous results.

Quality of Revenue Case Study

A real-world example illustrates this point. The O'Connor Group had a manufacturing client that, in its recent past, achieved revenue of $12 million, and a profit of $1.1 million. Six customers accounted for almost all of the revenue. Management believed they could increase profits by expanding the customer base, so they pursued an aggressive growth strategy. A national equipment leasing company gave them very generous terms on millions in new equipment. They increased staffing, and encouraged the sales team to aggressively pursue new customers. The growth strategy worked – revenue increased 25%, to $15 million, and sales brought in two dozen new customers. However, the company lost $800k, the greatest loss in the company's history.

The problem was easy to see. After leveraging the balance sheet with millions of new debt (and a high monthly payment) management quickly realized that taking customers away from competitors was challenging. The only way to get new business was to undercut pricing dramatically. The CEO (a former salesperson) had concerns, but the sales team assured him prices would increase over time, and/or the customers would expand into more profitable product lines. Further, the COO achieved record efficiencies and production levels, overhead costs were absorbed, and Inventory turned over rapidly. Yet the company was losing money, and the losses accelerated each month. Nonetheless, the CEO continued with the strategy because he knew he had huge fixed costs (primarily equipment lease payments) that had to be absorbed.

By the time The O'Connor Group was hired, the losses had almost completely eroded liquidity. An extensive analysis of revenue broke it down by source and calculated profitability at a variety of levels. The data revealed what was expected – the revenue initiative was a complete failure. The record loss for the year came directly from the $4 million of new revenue. Profitability from the six "core" customers declined from the prior year, due to management's new pricing policies.

The problem described above is one we see repeatedly, though this is an extreme example. One thing we reinforce to our clients is that their business exists to make money, not to absorb costs. When you price jobs so that you lose money on each unit, you do not make it up in volume.

Once we made that clear to management, the solution became obvious – raise prices to profitable levels, and if the business leaves, dismantle the new infrastructure accordingly. Management never considered this option because it believed it was hostage to the equipment lease payments. Predictably, customers refused price increases, and revenue dropped substantially. TOG formulated and implemented a plan to downsize the equipment by negotiating a) strategic returns of a portion of the leased equipment; b) discounted payoffs to the lessor funded by sales of owned equipment now considered surplus; and c) a modified payment plan on the remaining leases that improved cash flow. Several members of the management team left the company. The company revised its commission policy for salespeople, calculating it based on gross profit instead of revenue. The COO's job performance criteria also included measures tied to profitability rather than production, exclusively.

A Lesson Learned

Quality of Revenue is a very important consideration for every company. In order to maintain it, companies can do the following:

• Understand that revenue growth is a means to an end, not an end in itself;
• Measure how profitable you are by customer, location, product type, service provided, employee, etc.;
• Constantly reassess results. It is fine to lower pricing to attract new customers, but always keep in mind what the reduction was supposed to accomplish. Is the goal to cross-sell? Did you intend to raise prices gradually? The plan needs to be defined, and results need to be measured against it;
• Think outside the box. In the example above, management thought they were in a corner and continued paying for equipment they could not afford. They never considered returning the equipment as an option;
• Align the interests of all departments with the bottom line. All oars in the boat need to pull in the same direction;
• Admit mistakes and move on. New challenges are exciting, and goals and expectations need to be established. If the results fail to meet expectations, managers should not be afraid to radically alter plans.

To learn more about you can help your clients get – and stay – on the right track, contact The O’Connor Group at 1-888-9-BIZ-FIX or email us at info@theoconnorgroup.com.

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