Which of the Four Horsemen of Profitability should you bet on?

Those who have experienced the ups and downs of economic upheaval know that uncertainty intensifies the short-term focus of the company. When expectations and demands surrounding profitability and liquidity rise, it is crucial to know how different measures impacts the bottom line – and keeps the company in the game.  

Soaring energy prices, inflation and interest rates 

According to McKinsey, economic forecasters have trimmed their growth estimates throughout 2022. And the OECD composite leading indicators also point to general economic deceleration in the coming months. This narrowing of growth outlooks is a consequence of surging energy and food prices, the effects of the war in Ukraine on supply and trade, and rising policy interest rates intended to cool inflation. 

In such turbulent times, robust leadership and clear strategy becomes more important.  Unfortunately, strategy is an elusive term plagued with ambiguity. You don’t even get a clear answer if you look up the word in the dictionary!  

However, if we look to global authorities like Michael Porter, Roger Martin and Richard Rumelt, strategy shares a common denominator: making choices. Clear, powerful and specific choices about what to do. And even more importantly: what not to do.  

In theory it should be easy and straightforward. In reality, managers and executives find it extremely difficult (and sometimes terrifying) because it means doing some things at the expense of others. Many are reluctant to commit to such decisions in fear of the consequences that may follow. And who can blame them? Especially in times of economic unpredictability, when the consequences of making wrong choices can make or break the company’s profitability and survival.   

In order to equip companies with the tools and confidence they need to navigate through rough times, the leadership must have easy access to insight and data. This will enable them to make better and more informed strategic decisions on the path to success.  

What matters the most for profitability? 

When companies must take action to ensure profitability in challenging times, they must decide on which of the following “four horsemen of profitability” to place their bets on: 

1. Sell more goods and services 
2. Increase price level of goods and services 
3. Reduce fixed costs 
4. Reduce variable costs 

To find out how much these measures affect profitability, professors Raju and Zhang of the Wharton School of the University of Pennsylvania delved into the empirical findings from the unviersity’s database, and found that a: 

• 1% increase of sales can increase profitability by approximately 3-4%   
• 1% increase of price can increase profitability by approximately 10% 
• 1% reduction of fixed costs can increase profitability by approximately 3%
• 1% reduction of variable costs can increase profitability by approximately 6.5% 

If the findings from Raju and Zhang are to be used as basis for making decisions to improve profitability, companies should gear their focus on taking measures that can help them get paid better for what they sell.  

However, while these findings provide valuable insights on how to increase profitability, it does not mean that the same applies for every business. After all, each business operates with their own cost structures, price margins and other conditions and factors that must be taken into consideration.  

For each company to obtain the foundation it needs to make smart decisions, finance leaders and their teams must have a complete picture of all the moving parts that makes up the organization’s value chain. With that information they will be able to make forecasts and simulate possible outcomes of pulling the different profitability-levers – and get a sense of what will generate the best financial outcome.  

Adapting better and faster with rolling forecasts 

Even before the writing on the wall told us about rising inflation, energy prices and interest rates, digitization had already ushered in an age where fast-paced changes demanded more efficient and accurate ways of working.  

A consequence of this has been that an increasing number of companies have questioned whether they can continue to rely on spreadsheets and traditional budgeting. While spreadsheet software has been the standard go-to tool in the past for budgeting and planning, the lack of efficiency and risk of human error has become a major obstacle.  

This may explain why a growing number of companies are seeking to replace classic budgeting management with rolling forecasts. According to FSN – Future of Planning, Budgeting and Forecasting Survey 2017, companies who operate using rolling forecasts will have a four times greater chance of reacting quickly to changes in the market.  

When talking about transitioning the company toward rolling forecasts, one cannot avoid the elephant in the room that is spreadsheets. According to BARC Annual Survey, more than 90% of Excel users have problems using spreadsheets for planning.  

While rolling forecasts has many potential benefits, finance departments find it extremely difficult to work efficiently and deliver accurate numbers when attempting to make this transition with spreadsheets as the only tool.  

It doesn’t take much effort to figure out why this is the case. One of the major reasons is the fact that you must run several rounds of simulations to see the effect of different path choices on future liquidity budget and cash flow. To make matters worse (and more time-consuming), one would also have to create best, worst, and most likely variants for each possible outcome. The process of embarking on this journey with only spreadsheets can quickly lead to the dream of rolling forecasts ending in becoming nothing short of a complicated nightmare.  

Traditional budgeting vs. rolling forecasts requires different approaches. For rolling forecasts, you can’t have a cumbersome spreadsheet. You need a better tool for the job, where codes and algorithms make sure you can run multiple simulations quickly – with 100% accuracy.  

In our work with the CFO Platform’s solution for Budgeting and Forecasting, the primary focus has been to create a tool that enables finance teams to effortlessly simulate business strategies and scenarios with different assumptions and business drivers. With a clear, streamlined procedure, the software makes it much easier to identify the organization’s most important value drivers, and build a simulation model based on the company’s business logic and structure.  

As a result, it is possible for finance departments to quickly access to information they need, avoid curve balls, and react in time to keep the business afloat.   

Determination and action in uncertain times 

When things get rough, the finance department often bears the most weight when it comes to making good decisions for the survival of the company. Should the company double down, cut back, or simply wait for the storm to pass?  

These are choices that has to be made, and nothing is more important than having a good strategy to combat the many uncertainties and plan ahead for the future.  

By having the right budgeting tool, we can quickly have the numbers we need, simulate what will happen – and get the information we need to decide on the best course of action —whether it be increased sales, higher prices, or reducing costs.