Where Will Your Next Profits Come From?
Harvard Business Review The Conversation
By Mark W. Johnson
How does your company make its money? I'll wager it's not in the way that you think. Not entirely, at any rate.
I typed the term "profit formula" into
That's not really surprising, since most companies measure profits in terms of margins, whether gross or net. What could be more rational? After all, at its most basic level, a company's profit formula has two parts — revenue and costs. Sell something for more than it cost you to make it and you turn a profit. How much higher revenue is than cost for each transaction is the margin. So it seems logical that focusing on margins is a good way to keep track of your profits.
And it is. But it's also a good way to close your organization off to the possibility of making future profits.
To understand why, let me lay out what I believe is a more useful way to think of profits — a formulation I've broken out into four parts to make it easier to view profit generation strategically. In this framework, the factors you need to consider when determining how your company will turn a profit for a given offering are:
# Revenue model (price x quantity)
# Cost structure (direct costs, overhead, economies of scale and scope)
# Margin model (how much each transaction must net to reach the desired profit level)
# Resource velocity (how quickly resources are turned into offerings — leadtimes, throughput, inventory turns, asset utilization).
Companies that habitually use margins to judge how well their current model is working often make the mistake of using them to judge how feasible a new opportunity would be, too. That leads them to reject out of hand any new business that might involve lower margins.
But as you can see from this framework, your current company's margin requirements are a function of many other factors: the price you've set, the quantities you sell, your fixed costs, your economies of scale or scope, the speed with which you can get paid. Change any of these factors and the margins required to turn a profit change as well.
Granted, changing fixed costs, overhead, or the way in which customers pay you is hard for incumbents. But the very fact that it's hard to think about profit generation in other terms is what creates opportunities — if not for you, then for focused start-ups unencumbered with your fixed costs or your need to sell at a certain price to maintain margin.
IBM, the wily business model innovator that it is recognized the threat that
Executives focus intently on margins for a reason — they're the first indicator of risks to the business. I won't argue with that. But too great a focus on margins carries risks of its own. How vulnerable would your company be to a competitor that has thought up a novel way to turn a profit in your market? You won't begin to be able to answer that question unless you understand your entire profit formula, not just its margin requirements, and ask yourself how it might otherwise work.