Integration strategy key to margin management: new methodologies allow companies to take a systematic approach to improving profitability without having to undertake a massive transformation. (Profitability).

There is an old New England saying, "What a tea bag and management have in common is that you don't know if they are any good until you put them in hot water." In today's business climate, there is sufficient "hot water" for both tea bags and management. The "build market share and someday profits will come" philosophy of the dot-coin era is being challenged by shareholders who are demanding profitable growth, with the emphasis on profitable.

A very useful approach to improving a company's profit performance is to use new gross margin management methodology. MarginMax[C], for instance, is a cohesive, systematic approach that provides a way to generate significant profits by focusing on the existing value-creating activities of the core business, without embarking on a major transformation that could take years to implement.

Improved gross margins are one of the most powerful levers of financial performance. A $500 million company that can increase its gross margin rate by 3 percent will add $9 million to the bottom line and $225 million in shareholder value (Figure 1).

Key Drivers

Many companies do not fully understand or utilize the powerful leverage of a system like MarginMax, which focuses on gross margin as the leverage point and integrates all the key drivers of gross margin into a comprehensive improvement program that aligns from strategy to daily execution. The key word is integrated. Companies that employ this integrated methodology will be more successful in delivering sales growth, bottom-line results and shareholder value. Added bonuses of MarginMax are improved customer satisfaction and the removal of internal barriers that separate departments and disciplines.

Gross margins are defined as both gross profit dollars and gross margin percentage. MarginMax aligns the organization to facilitate understanding and management of all the key drivers that maximize gross margin. These critical drivers are:

Operational performance

Pricing strategy and process

Product management process

Customer management process

Sales effectiveness

Each of these drivers must have concrete, margin-related objectives; concise, margin-related measurements; and clear ownership in the organization. Each has a substantial process element, which requires a strong cross-functional team effort for successful implementation and continuous improvement.

This process-aligned team approach may require changes for a company with a traditional functional organizational structure and mentality. Maximizing gross margins requires focus on the right drivers and alignment of these objectives by the senior management team to the front-line people closest to the action. Integration, focus, alignment and teamwork sound simple conceptually, but few companies do it. The good news is that all can.

Synergy Among the Key Drivers

The synergy that results from understanding the interdependence of these key drivers -- and executing an integrated approach -- will produce results greater than the simple sum of the parts. Each key margin driver improvement will have a direct, positive impact on gross margin. Synergy derives from the fact as one driver improves, the other drivers will, too.

As operational performance improves, for example, customer response time is faster, on-time delivery increases and quality improves. This means that sales effectiveness is also enhanced -- the sales force has more selling time because salespeople no longer have to expedite orders, process returns or explain quality problems. Plus, customer turnover declines. Both result in increased sales.

Operational Performance

Operational performance is often the primary focus of many margin-improvement programs featuring the management mantra -- "Our margins are declining, so we have to reduce our manufacturing costs." Yet manufacturing has had more attention over the last 30 years than any other functional area, with efforts to improve productivity, yields and cycle time. More recently, as the labor content of U.S. manufacturing has become a much smaller percentage of total product cost, many companies have employed supply chain management to reduce the material content of their product cost.

So, while improving operational performance may yield significant benefits in some companies, operational improvement opportunities in others may not be sufficient to justify an integrated gross margin management ( IGMM) program, which targets a 5 to 10 percent boost in margins.

Surprisingly, the other four key drivers of margin maximization are often not comprehensively included in margin improvement programs, yet they will usually improve gross margin as much as, if not more than, operational improvements. While operational performance is primarily inward-facing, the other four key drivers are "customer facing" and are more subjective and complex to manage.

Pricing Strategy and Process

Most senior executives would agree that a company's pricing strategy and process is a key driver of gross margins. Yet at many companies, pricing management is not strategic. Moreover, the pricing process is mysterious, with responsibility often abdicated to the sales force or distribution channel. The only constant is that pricing is usually the most emotionally charged issue at the company. MarginMax requires businesses to create a process that drives more profitable pricing using logic, not emotion.

The most common pricing strategy is cost-based pricing, which, in theory, provides a reasonable return on costs. In reality, though, it is a roadmap for mediocre gross margin performance because it is difficult to determine a product's unit cost before determining its price, as the cost is dependent upon volume. The bias of cost-based pricing is to overprice in weak markets and underprice in strong markets, hurting gross margins (See Figure 3, adapted from the book The Strategy and Tactics of Pricing, by Thomas T. Nagel and Reed K. Holden.)

Cost-based pricing is internally driven, starting with a product concept that hopefully has a market. The next question is, can the product be sold at a price to recover costs and contribute a reasonable return? Often, it becomes clear that the product is not accepted in the marketplace or has to be discounted significantly to sell.

Value-based pricing begins with the customer's product need. The next steps are identifying the value proposition and determining the price, which dictates the cost targets and influences the product design. The value-based pricing model is a customer/market-driven product design with a target price that can be sold successfully, helping gross margin.

Pricing Scorecard: One tool used to test the soundness of the pricing strategy and process is a Pricing Scorecard, which evaluates 10 key attributes of the pricing strategy and process, such as pricing strategy alignment, product value in the marketplace, customer price sensitivity and profitability. These key pricing attributes are weighted for relevance in the particular industry, and company-specific pricing elements are added as appropriate to ensure that the Pricing Scorecard is tailored to each company.

Product Management Process

This process breaks down into two major sub-processes: the new-product development (NPD) process and the product life-cycle process. The NPD process can generally be defined as extending from product concept to manufacturability validation. This process is critical to gross margin maximization because new, leading-edge products will command a higher gross margin.

More Isn't Better: Companies frequently have two to three times too many projects being actively worked in the NPD process in relation to their available resources. In fact, companies often boast of the large number of projects in development -- but this "more is better" philosophy results in lengthening the time required to market. This dissipates the product's sales and gross margin opportunities.

Deployment of new-product development resources should be CEO and executive team decisions that employ a consistent, rigorous prioritization. Once the clutter and low-payback projects have been killed and attention focused on a critical few, the time to market and the quality of the process will improve significantly.

The second sub-process, the product life cycle, involves managing all aspects of the product, from its introduction to its elimination from the product line. Many consumer products companies do an excellent job of managing products from the emerging stage to maturity by evaluating unit sales, pricing, revenues, gross profit margins, product enhancements, competition and the veracity of the value proposition on a systematic, disciplined basis.

The other extreme is the situation in which products are removed from the line only when they die of natural causes (they no longer sell). This approach results in a product distribution in which 80 percent of the gross margin is derived from 20 percent or less of the products. With a product distribution curve this steep, approximately 40 percent of the products are either at breakeven status or are losing money on a fully loaded basis. A very recent analysis of a plumbing-fixture manufacturer revealed that 8 percent of the products contributed 80 percent of gross margin -- creating an incredible gross margin opportunity.

To maximize gross margins, companies need to establish a formal product evaluation process that includes a product margin matrix assessment, a comparison of planned margin performance to actual and an evaluation of product improvement plans.

Customer Management Process

This process is based on author Steven Covey's principle that for a customer relationship to be lasting, it must be based on a "win-win" proposition in which each party understands the other's objectives and expectations. Customer-service initiatives are to be applauded -- but superior customer service can be realized only if both parties perform their obligations. For example, if the customer does not deliver required materials or designs on time, changes its forecast continually or rejects a product unrealistically, gross margins will suffer until a team effort is established with the customer to fix the root-cause problems.

An effective customer management process has a number of additional attributes, such as: a target market and customer identification model; growth, retention and pruning strategies; mutually helpful operating and escalation policies; a mutually useful and communications-intensive customer management program; ownership support and service programs; and customer service and technical service staff compensation tied to gross margin measurements.

Customer profitability is typically measured at the gross profit level, or at a contribution level, defined as gross profit less direct expenses, such as commissions. If a company does not understand and manage customer profitability, it is missing an opportunity to use a key tool to manage customers' expectations and maximize gross margins.

Sales Effectiveness

Sales effectiveness focuses mainly on two areas.

Identify opportunities to increase sales, which will enhance gross margins, particularly if the company has a high fixed-cost structure. Sales can be boosted through: proper channel design; savvy deployment; lead-generation processes; a differentiated, customer-value-based sales team strategy; sales partner selection, support and communication programs; a clear sales process that keys on the customer's buying process; a good sales methodology that is used and coached uniformly; a complete sales toolbox, and relationship management.

Achieving gross margin objectives through alignment, the second area related to sales effectiveness -- admittedly tough and emotional -- means the sales organization must be aligned with the company's gross margin objectives and must assume ownership of gross margins. Sales represents the "front line" of gross profit management because the salesperson is often the decision point for determining the product mix, pricing levels, inventory commitments, support commitments, terms and conditions and customer expectations.

Instead of establishing a myriad of bureaucratic rules to manage and control salespeople, the company has to clearly communicate its gross margin objectives, provide the tools required to manage gross margins, train the sales force in business management skills and align compensation to the margin objectives. Then step back and let the sales force get on with it.

Once a company has established gross margin as a top objective and begins to focus on the key drivers, each functional organization will start to see improvements after three months. Substantial results will be realized in 6 to 12 months, thanks to the synergistic results coming from an integrated margin management approach. Each key driver will have significant impacts outside of the functional organization that "owns" its implementation.

Process Perspective and Teamwork

The key drivers of margin all depend on processes, from pricing to manufacturing, which require teamwork among the functional organizations. For example, the effectiveness of the manufacturing process is heavily dependent on inputs from sales, product management and customer management. To implement MarginMax, a process perspective must be used, facilitated by a strong team orientation.

A company that transforms itself from a "sales/cost control" company to an integrated gross margin management approach can expect to improve gross margins by 5 to 10 percent. This translates to a 2 to 4 percent improvement for a 40 percent gross margin company. For a $500 million company at the middle of the improvement range, the impact looks something like this:

* Gross margin impact (3 percent improvement): $15 million

* Bottom-line impact (40 percent tax rate): $9 million

* Shareholder value (25X): $225 million.

The bonuses include: improved customer satisfaction, a more productive sales force; reduced manufacturing costs; a faster, tighter product management process; less pricing pressure; and a highly aligned, motivated team. All in all, not a bad return.

[FIGURE 1 OMITTED]

John F. Stasz ([e-mail]) is Managing Partner of Van Winkle Associates, a business advisory firm that developed the MarginMax[C] methodology.