Profit Optimization - Can We Possibly Argue With The Objective?

Profit Optimization - Can We Possibly Argue With The Objective?
Featured Author - Olin Thompson - August 11, 2003

Introduction

Profit Optimization's objective is to maximize profits and the term has become a popular buzzword. Its very title speaks to an objective that every business can agree upon. Looking at a variety of sources, we see that this one topic is, like many buzzwords, really a collection of ideas with various vendors using the buzzword to sell a variety of products. But, those vendors are claiming increases in operating profit of as much as 10-40%. So, let's try to make some sense out of it.

The best-known example of Profit Optimization is the airlines. The variables that most control profits are the load factor (the percentage of seats with passengers) and the average revenue per seat. These variables are continually monitored with the price per seat being continually modified to meet the objective of the maximum profit for that flight.

The "why" of Profit Optimization is easy? The objective is to increase profits and we can all agree on that objective. The "how" of Profit Optimization is not so easy. A simple analysis of increasing profits may say, "raise prices" or "cut expenses" or "sell more". While all of these simple solutions are right, the problem is always more complex. For example, if we "raise prices" will the customers still buy? If we "cut expenses" will quality suffer and drive away customers or will our warrantee cost increase to the extent that we actually have the opposite impact? "Selling more" is not as simple because we do not control our customers, we don't know if they will buy more, and if they do, the question becomes, can we deliver? In reality, all these simple solutions are dependent upon each other and many more variables. Profit Optimization is not a simple objective; it is a very complex objective.

Profit Optimization - What is it?

Profit Optimization is looking at the profit critical variables of the business and advising management on how these variables can be changed to achieve greater total profitability. In your business, what variables control or impact profitability? Some variables are obvious (selling price) while others are not as oblivious (queue time in a production facility). Since these variables are interrelated, the best solution considers the variables in a holistic view of the business so that over adjusting some variables does not negatively impact others.

Like the airlines, the best solution continually monitors the situation in "real time" to get current information to make quick decisions. (Note - the phrase "real time" is used by many in the Profit Optimization field but the definition they imply is really one of soon enough or "right time" as opposed to the formal definition which is instantaneous information") The objective of Profit Optimization is maximizing total profits by considering the entire picture.

Different industries and vendors approach things differently. Some focus on optimization pricing, some on operational efficiency, some on capacity utilization and some on product and customer mix. Most require more than one approach to satisfy the core objective, maximizing total profitability.

But doesn't accounting or costing do the same thing? No, accounting and cost accounting reports and analyses history but does not suggest alternatives or understand the complex relationships. To deal with complex relationships (like overhead) accounting makes simplifying assumptions like overhead is proportional to labor or all products get the same dollar amount of overhead per unit. Accounting and costing traditionally use financial periods for their analysis that is far from the "real time" information required for Profit Optimization. Accounting takes an accounting view of the world while Profit Optimization takes an operations view.

A number of vendors and service providers offer Profit Optimization. Their approaches vary in both the types of information they consider and how they utilize that information. The background of the vendor or their target market slants how the vendor and their products and services see these variables. Therefore, we see vendors who concentrate on asset intensive industries (chemical, paper, metals) doing more with asset utilization variables, for example product changeovers, maintenance, etc. Therefore, we see vendors focused on retail doing more with merchandizing variables, for example product mix, discounting and promotions, seasonal issues, etc.

Vendor Landscape

Since Profit Optimization has evolved into a buzzword, we see many vendors using it to describe both new and existing products. As with most categories of software, two types of vendors exist. Vendors taking a horizontal approach see the application as one where a single set of code can be utilized by a very large array of industries. Vendors taking a vertical approach address the needs of specific industries and concentrate on the unique needs of those industries.

The horizontal vendors work across a wide spectrum of industries. They may claim to be applicable to a number of different industries also covered by the vertical vendors but, in general, they lack industry specific functions. Some examples of horizontal vendors include:

• Acorn Systems
• Lexicon
• Manugistics
• I2 Technologies
• Rapt

Verticals vendors offer products and processes tuned to the needs of a specific industry. The solution focuses on the revenue and cost drivers for that industry. For example, a consumer goods company needs to understand the impact of promotion and new product introduction on demand in order to optimize profits or a retailer needs to understand the impact of markdowns. Some examples of vertical markets and the vendors who service those industries include:

Recommendations

Do you need Profit Optimization? In theory, every business can do a better job of profitability. If you are the profit leader in your segment, do you think you can be doing a better job? If so, Profit Optimization may be meaningful. If you are not the leader you need to understand why. Yes, you can do an internal evaluation but often, internal resources cannot easily see the forest for the trees or they suffer from "incestuous reinforcement" (you all start with the same ideas, you keep telling each other that you are correct so you all get more convinced that you are right). For these reasons, a small dose of Profit Optimization services may give you the reasons and a game plan.

In reality, not all businesses are ready to benefit from Profit Optimization. All Profit Optimization products and services are driven by information coming from your existing systems or that can economically be generated. Profit Optimization is not magic, it starts with information and if you do not have the right information, you will not get the right result.

Which type of vendor is right for you? If vendors exist that claim to focus on your industry, add them to your long list and look at them first. These vendors believe that they can do a better job for you, ask them why they feel that way. Look for an understanding of your industry's revenue, its cost and profit drivers, and the product features that take them into consideration. Ask for industry specific references. If the vertical vendors do not exist, or if they do not give you adequate reason to think that a vertical vendor is required, a horizontal vendor is appropriate.

About the Author

Olin Thompson is a principal of Process ERP Partners. He has over 25 years experience as an executive in the software industry. Olin has been called "the Father of Process ERP." He is a frequent author and an award-winning speaker on topics of gaining value from ERP, SCP, e-commerce and the impact of technology on industry.

He can be reached at Olin@ProcessERP.com.