Optimizing Back Office Operations

Best Practices to Maximize Profitability

Zahid Khalid

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470531891
• eBook ISBN: 9780470603956
• Edition: 1
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

According to industry experts, a typical one billion dollar company spends approximately $27 million on unnecessary working capital and inefficient processing functions because they lack visibility into the financial supply chain. Optimizing Back Office Operations: Best Practices to Maximize Profitability uses examples and case studies to show how cost optimization—and not cost reduction—in the core back office operations is the right approach to maximizing profitability and enterprise value. Implementation guidance is provided for Executives, CFOs, and Controllers on transitioning from outdated processes to a fully-optimized financial supply chain.

CHAPTER 1

Profits: The Reason a Business Exists

The essence of a successful business is really quite simple. It is your ability to offer a product or service that people will pay for at a price sufficiently above your costs, ideally three or four or five times your cost, thereby giving you a profit that enables you to buy and to offer more products and services.

—Brian Tracy, Chairman, Brian Tracy International

All too often, we hear and read in the business media business leaders proclaim: “Our focus is on increasing shareholder value.” What is this value, and from whose perspective are they attempting to increase it? Using the definitions provided by titans of the business and investing world including Warren Buffett, Benjamin Graham, George Soros, and Peter Lynch, a shareholder with a short-term interest is merely a prospector. It is the long-term focused shareholder that is a true investor. These people are “owners of the business” in the true sense and those whose interests business leaders should be serving. Wall Street does not usually cater to their interests, and, all too often, business leaders cater more to Wall Street than to business owners. The evidence of this discrepancy between words and action surrounds us in the form of failed corporations, issues around excessive executive compensations, and accounting scandals of historic proportions.

Clearly there is a gap between what is being said and what actually is being done in this context. This gap can be translated most often into a differential of focus between short-term profit maximization and long-term sustainable profitability—on the surface it appears to be a case of harvesting low-hanging fruit. The actual causes of this phenomenon are complex and involve elements of human psychology, emotion, greed, and competitive nature. Here we look at only those aspects that are most relevant to the art and science of managing a business enterprise.

The core problem in this regard may well be linked to the historical concept of a public corporation and what exists in today’s environment. The dilution of ownership and the resulting imbalance of power in favor of management are evident in the daily headline news. Government intervention in this arena in the form of limits on executive compensation and other related measures will not solve the problem. Perhaps it is time to reconsider the fundamental structure of what we call a public company.

Profitability Defined

What is profitability? Most commonly, it is understood to mean “profits.” But that is not accurate. Profit-ability is the ability of a business to generate profits and it is an ongoing state of being, a steady state whereas profits are discrete events in time. In the context of long term versus short term, profits are the focus of short-term focused management whereas profitability is the focus of the longer-term focused management. We will see during the course of this book that only management that is focused on profitability is truly attempting to serve the best interests of the shareholders: the business owners.

Profits can be generated through superior operating performance as well as by using destructive short-term tactics such as unjustified plant closing, capability-destroying headcount reduction, and nonstrategic reductions in investment in new product lines and services. One name that comes to mind in this context is that of Albert John Dunlap, popularly known as “Chainsaw Al.” Named by Conde Nast Portfolio magazine one of the “Worst American CEOs of All Time,” he is barred by the SEC from serving as an officer or director of any public company as a result of his conduct at Sunbeam Corp. His formula for “increased profits and earnings” was to fire thousands of employees at once and close plants and factories. Wall Street loved him because of his ability to deliver higher earnings in a very short time. Investors (really prospectors) loved him for delivering high stock prices in a short time frame. Boards of directors loved him for his performance. None of these constituents bothered to ask the question that needed to be asked: What was the impact of Chainsaw Al ’s short-term profits-focused tactics on the profit-ability of the companies he was leading? Some very smart people lost sight of the difference between profits and profitability. During the course of his career and using his short -term profit-seeking management techniques, Chainsaw Al brought strong corporations, including Scott Paper and Crown Zellerbach, down on their knees. Dunlap was finally stopped when he attempted to use his methods to increase the share price of the Sunbeam -Oster Corporation. His plan failed when Sunbeam stock plummeted within four months after a dramatic temporary rise in price. It was discovered that Sunbeam’s revenues had been padded because Dunlap had given large discounts to retailers that bought far more merchandise than they could handle. While this positively affected the income statement (albeit through some accounting creativity), the excess merchandise had to be shipped to warehouses to be delivered later and added to the inventory balance sheet account. Rising inventory made the investors suspicious, and they eventually panicked, bringing down the stock price of Sunbeam. Dunlap was fired and agreed to pay $15 million to settle a shareholder lawsuit.

Profitability is a function of the internal and external factors that have long-term implications. It is a matter of how a business enterprise structures itself internally as well as how it positions itself to face the external forces in the marketplace in which it competes. Both have a strong bearing on the long - term competitiveness of the business. The most important consideration in this regard is agility, a concept we explore later. Agility in this context is the fundamental ability of a business to respond quickly and cost effectively to external forces and to be able to execute internal strategies in the face of a constantly changing competitive environment. It is a key component of a profitable business enterprise and is actualized through its platform for execution. Agility in this sense is both operational as well as financial. The focus of this book is on financial agility.

The key external factors of financial agility include:

• Competitive landscape

• Regulatory landscape

• Industry fundamentals

• Economic conditions

These external factors are not in the direct control of the management or the business enterprise. The competitive landscape is a complex web of forces that act on the business entity and give it either a competitive advantage or a disadvantage, depending on how it has positioned itself facing externally as well as how it has organized itself internally. Michael Porter summarized this in his “Five Forces Model,” as shown in Figure 1.1.¹

FIGURE 1.1 Porter Five-Forces Model

Ample material has been written on defining this external environment and the various generic strategies that deal with these forces. What has been lacking is a blueprint for the execution of these strategies. As Larry Bossidy, retired chief executive of Honeywell, captured so well in his book Execution: The Discipline of Getting Things Done: “When companies fail to deliver on their promises, the most frequent explanation is that the CEO’s strategy was wrong. But the strategy by itself is not often the cause. Strategies most often fail because they aren’t executed well.”²

The flawless execution Bossidy refers to is the domain of the internal factors of a business enterprise, which include:

• Organizational structure

• Organizational culture

• Capital structure

• Operating structure

• Management capabilities

• Upstream/downstream channel relationships

• The platform for execution

How a business chooses to carve out its market share is at the core an exercise in formulating its competitive strategy. At the highest level, it may choose one or a combination of the generic strategies—cost leadership, differentiation, segment focus. The rest of the internal factors then have to align with this core strategy decision. For example, companies that choose innovation as their core strategy must carefully plan and foster an organizational culture that supports innovation. A good example of this is Microsoft Corporation, where software developers are allowed a great deal of latitude in the work environment, including a very informal dress code, relaxed work environment, and casual interaction style with peers and even senior management. EDS, in contrast, has followed a segment focus strategy whereby it seeks customers and clients in large corporations that have traditionally valued a strict dress code and formal interaction style. Both are correct in fostering their respective cultures as each is aligned with the core strategy being executed.

Michael Porter gave this internal structure a name—the Value Chain—and suggests a generic representation as shown in Figure 1.2.

In essence, profitability speaks to the fundamental ability of the business to generate profits over the long term. Although sometimes profits may remain elusive due to external factors, the entity’s ability to generate profits remains intact at its core and will give it a competitive advantage over the long term. Among the internal factors listed earlier, all are rather well understood except the last one: platform for execution. We look at this in detail in Chapter 4, but for now, it is sufficient to understand that it is the digitized embodiment of the core business processes. It is what ensures that the strategies and resources of the business are leveraged optimally to maximize profits. Meddling with the profitability capabilities of a company during an economic downturn with the intention of cost cutting is an all-too-common mistake, and a tragic one. Leading organizations have learned to develop and invest in a platform for execution that does not need to be subjected to radical cost reductions for short-term reasons.

FIGURE 1.2 The Value Chain

Source: Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985).

It is the primary responsibility of senior management to focus on the internal factors that determine business profitability instead of on the quarterly results that drive the short-term stock price performance. Investor relations can be a matter of taking or conceding control. If control is conceded to short-term “prospectors” to prop up earnings, those very prospectors will take their profits and leave, since everything that is knowable about the stock is already factored into its stock price. This may help the short-term incentive compensation goals and profits objectives of some groups, but it does not necessarily turn out to be the right thing for the longer -term prospects of the organization. Lacking this long -term focus, intentionally or otherwise, leads to the eventual decline and even demise of the business. Examples of this are all around us: Think of Countrywide, Sunbeam, and Polaroid. All of them earned healthy profits for a long time due to superior profitability but neglected to stay focused on profitability and either filed for bankruptcy or ceased to exist altogether.

At the most basic level, we define profits as:

Profits = Revenue - Direct Costs - Indirect Costs

The area of controlling and minimizing direct costs is mature and attended to adequately by a majority of the business organizations through the use of supply chain management and procurement practices. It is the indirect costs—which constitute a significant portion of the overall costs—that are not as well managed. This is not to say that the importance of managing indirect costs is not well understood. Rather, the manner in which costs containment is undertaken by a vast majority of the business enterprises is not aligned with the best interests of shareholders—enterprise value creation. The management techniques most often employed in this regard are reactive in nature and do not contribute to long-term profitability. When I have asked audiences in seminars and presentations to share what comes to mind when they hear the phrase “cost reduction,” the answer always is “headcount reduction.” Yet it does not have to be this way, nor should it be. The up-and-down, yo-yo effect of hiring and firing is destructive to the very precious resources of human capital so often spoken passionately about by senior managements across the country. There has to be a better way, and there is. This is the realm of profitability and platform for execution that is the focus of this book.

In later chapters, we examine this area more closely and see some best practices that help maximize profitability by streamlining and leveraging back-office capabilities to minimize this yo-yo effect. Some layoffs may be unavoidable; but many others are due to a lack of process optimization, automation, integration, and standardization that cause this value-destroying phenomenon.

Profitability Equation and Related Metrics

Profitability of a business enterprise is analyzed and measured in various ways, depending on the objectives of the analysis. Some of the most common measures are:

• Return on sales (ROS)

• Return on equity (ROE)

• Return on assets (ROA)

• Return on invested capital (ROIC)

The basic economic viability of the industry in which a business competes is determined by its gross margin, defined as:

(Net Revenue - Cost of Goods Sold)/Net Revenue

Although this metric varies somewhat from one firm to another within the same industry, its limits are defined by the industry as a whole. As an example, Dr Pepper Snapple Group and Pepsi Co. compete in the beverages industry segment with an order-of-magnitude difference in revenue size, with Pepsi having the larger share. In spite of the advantage enjoyed by Pepsi due to economies of scale, the cost ...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Preface
• CHAPTER 1 - Profits: The Reason a Business Exists
• CHAPTER 2 - Cost and Capability: Strategic Choices
• CHAPTER 3 - Financial Supply Chain: Entering the Gold Mine
• CHAPTER 4 - Platform for Execution: A System for Maximizing Profits
• CHAPTER 5 - Optimizing Accounts Payable
• CHAPTER 6 - Optimizing Accounts Receivable
• CHAPTER 7 - Optimizing Purchasing
• CHAPTER 8 - Optimizing Treasury Operations
• Epilogue
• Index