#319 from Innovative Leader Volume 7, Number 1          January 1998

Profitability Mechanism and the Competitive Edge
by Sandra Donovan, Ph.D.

Dr. Donovan, president of Donovan Associates, is a consultant to senior management on increasing profits, achieving growth, commercializing technology, and improving operating
effectiveness.  You can reach her at ssdonovan@aol.com; (609) 936-1880.

Conventional wisdom tells us to marry our company's strengths with our customers' needs in order to be competitive.  But merely being competitive is no longer enough.  How can we win the competition game?  Consider focusing on your Profitability Mechanism.

A Profitability Mechanism describes the few, specific, key items or actions that have the most impact of the profitability of a product or service.  Can you pinpoint those specific factors that make up the Profitability Mechanism in your business?  In my work with senior executives, I’m frequently surprised to learn that they haven’t viewed their businesses in terms of the specific factors that most lever their profitability.  These executives are missing an effective way to view their bottom line--and enhance their company's competitive edge.  To see how this works, here's an example.

Example:  Commodity Chemicals

In a large-volume, commodity chemicals operation, market price is set by the supply/demand relationship.  Raw materials comprise the greatest portion of delivered costs, and greatest operating efficiency for large-scale plants is obtained by running close to capacity around the clock seven days a week.  Moreover, a small fraction-of-a-cent differential in cost or price is significantly magnified by the huge volumes involved. 

Thus, the Profitability Mechanism for a commodity chemical facility includes a favorable supply/demand relationship, a cost-advantaged raw materials source, an efficient, continuously

operating world-scale plant, the wherewithal to move raw materials and products continuously, and the ability to sell product at favorable to no-less-than break-even prices.

What can the managers of a chemicals plant do to influence the Profitability Mechanism to their advantage?  This example is more than hypothetical; I faced this issue when I was an officer of Standard Oil Chemicals, and general manager of its Nitrogen Chemicals Division.

We could control--or at least influence--four of the components of the Profitability Mechanism, namely, the cost of raw materials, size and operation of the plant, logistical movement of raw materials and products, and ability to sell product. 

In the Nitrogen Chemicals Division, about 80 percent of the raw material costs to make ammonia -- a major product in itself as well as feedstock for other Nitrogen Division products -- was the cost of natural gas. Unfortunately, when I became the head of the division, our costs for natural gas from external vendors were far too expensive, in relationship to the market price of the final products, for the division to ever be profitable.

But luck was on our side: I took the job just as natural gas was being deregulated.  This meant that a customer could contract for its own gas purchase and transport and not be dependent upon the traditional natural-gas supply chains.  Today, natural gas deregulation is history, but current changes in utilities and telephone service are reminiscent of our environment then.

Thanks to aggressive, hard work, we built our own acquisition program for natural gas and cut raw material costs to enable profitability, assuming we did everything else right.  

That "everything else" included the Profitability Mechanism items we could influence, the second being plant size and operation.  A basic philosophy within Standard Oil was always to

size major units at world-scale, and to build in a manner that made future expansions very cost-effective.  That’s how our division's ammonia plant was built, and we were the beneficiaries of this foresight.  We kept the plant running continuously, and we maintained spares of critical components on site to minimize any down time.

Materials movement was the next item we addressed.  Our knowledgeable and hard-working professionals in charge of logistics needed to step back and examine the underpinnings of their operation.  We did this through benchmarking and, with what we learned, we were able to improve productivity and reduce costs, even though the volume of products was increasing during this period. 

The final Profitability Mechanism item within our control was the ability to sell all of our production.  We had a number of different products, each with its own market and margins.

Within broad limits, we could produce the mix of products wanted by the markets and, obviously, we wanted to produce that mix of products that would offer the optimum combination of margins in the marketplace.

We quickly realized that manufacturing was producing as much of everything as seemed convenient and logical to make, and that the sales force had no insights as to the different margins on different products.  To both manufacturing and sales, a ton of one product was the same as a ton of another product. 

Our approach to optimizing revenue was to introduce a simple tool to the sales force that enabled them to understand the margin on each product and to distribute their energies accordingly.  Once they had this information, the sales force could optimize revenues and margins.  This led, in turn, to being able to instruct manufacturing each month on the best product mix to produce.  As a result, both revenues and margins improved. 

Because cost of natural gas comprised such a large proportion of manufacturing costs, we found that reducing this expense and running the world-scale plant continuously had the biggest impact on profits.  The next most important factor was optimizing the mix of products made and sold. Improving materials logistics also had a meaningful impact on profits.

There was, however, one Profitability Mechanism item over which we really had no control: The supply/demand balance in the marketplace for a product.  We were one of many producers worldwide, and had to be guided by the conditions in the marketplace.  Since we couldn't control the supply/demand balance, we did the next best thing, and that was to preferentially manufacture the products that we felt would be tight, and not to release additional production to an already oversupplied situation.

Coupling Profitability Mechanism to Competitive Edge

To achieve a competitive edge, you must couple the Profitability Mechanism to one of two ways.

1. "Be the Best" at providing your product or service with regard to those elements that most impact the Profitability Mechanism.  In other words, "Be the Best at Playing the Game."  This is what we did for the Nitrogen Chemicals Division. A world-scale plant operating continuously with attractively priced natural gas, a focused sales force, effective materials logistics, and attention paid to market conditions made our division the best in the region at supplying quality products, on time and cost-effectively for thousands of customers.

2. Use your company's unique expertise to "Change the Profitability Mechanism" to your advantage. In other words, "Change the Rules of the Game."  Microsoft Corporation is a
classic example of a company that changed the Profitability Mechanism by changing the ground rules.  Mainframe computers dominated the industry in the early '80s, and conventional wisdom agreed that personal computers were just a curiosity, a toy.

Bill Gates, however, had the vision to realize that the barrier to widespread use of personal computers was user-friendly technology.  He introduced the necessary software, and the
explosive growth of the Microsoft Corporation—and parallel decline in IBM, the leading mainframe computer corporation—is history.

A company is usually suited to either change the rules or to be the best at playing the game, but not both.  Often, an agile company with good research and development and engineering capabilities will find it’s best equipped to change the rules of the game.  It can invent new products and services, change the supply chain, and define its own Profitability Mechanism.  Microsoft is not unique: High-tech companies including Intel, Cisco Systems, America Online and Netscape have all reinvented their industries and become dominant players in the process.

Often a well-capitalized company with global presence--particularly in a mature industry--will find its advantage is to leverage its vast resources to be best at playing the game.  Good examples of these best-in-class leaders are Procter & Gamble, GE and Coca-Cola.

How do innovative companies change the rules of the game?  They start by identifying the standard conventions, assumptions or perspectives in their industry.  A classic example of a change in perspective is realizing that orange juice can be a drink at times other than breakfast.  A company in the hospitality business might examine why the charge for hotel rooms must be from a typical check-in time of 4 p.m. to check-out time of noon the following day.  Why can't hotel room charges be on a rolling 24-hour basis like rental cars?  Many conventions are so ingrained that we become blind to them.

The next step is to explore what would happen if these conventions or assumptions didn’t exist, or were the opposite of what they are, or if new conditions (expanding global markets, new technology, greater productivity) or different Profitability Mechanisms were substituted.  Thinking "outside of the box" in this manner can prove quite illuminating.

Finally, it’s necessary to explore what combination of changes to conventions, assumptions, perspectives or Profitability Mechanism you can deliver. In doing this, play from your company's core competencies and strength, and seek to implement the changes that offer the greatest leverage and probability of success.

Can you identify the Profitability Mechanism for each of your different product or services lines?  Is your company better suited to strive to "Be the Best at Playing the Game," or is it in a position to "Change the Rules of the Game"?  Whichever route you choose, profitability for your product or service can be increased through appropriate coupling of the Profitability Mechanism with one of the two ways to enhance your company's competitive edge.

©1997 Sandra Donovan