How to Calculate Risk Based on Where Your Profits Come From
If most midsize companies have a formal risk management process, why did so many fail even in pre-pandemic years? The problem is that risk heat maps—many companies’ primary tool for assessing risk—have fatal deficiencies.
The risk heat map process looks at big, blunt risks (like sales force effectiveness) but doesn’t clearly identify the more granular and immediate risk elements that threaten profitability and possibly survival, especially in today’s fast-changing markets. The good news is that transaction-based profit metrics greatly increase your risk management effectiveness.
The traditional risk heat map
A risk heat map is simply a mapping of various business elements’ magnitude of risk. An element’s importance is on one axis, and the likelihood of problems is on the other. For example, consider Coastal Distributors (not their real name), a $650 million industrial products distributor:
- The company’s sales force is critical to its success, so its importance is high, while its sales reps are numerous and well trained, so the likelihood of problems is low.
- Coastal ships most of its products through its network of distribution centers, so its importance is high, but if a problem were to arise in one facility, it could easily use a nearby facility to serve the affected customers, so the likelihood of disruption is medium.
- The company uses technical representatives to help its customers, so the importance is medium, but it also uses an outsourced service to supplement its in-house team. The outsourced vendor could increase its involvement, so the likelihood of disruption is low.
The following figure shows Coastal’s risk heat map.
What Coastal’s risk heat map fails to show is that only 9% of the company’s customers produce over 150% of their profits, and many of these customers’ key decision makers chose Coastal specifically for its in-house technical expertise. It also fails to show that 3% of their products produce over 85% of their profits, and these products are subject to supply disruptions.
In addition, the risk management team was aware that additive manufacturing, a new technology in which products are formed from a powder-like substance and then hardened by heat, rather than being sculpted by cutting tools, was on the horizon. However, they weren’t worried because the market penetration of the niche competitors specializing in this innovation was less than 6%, so they left it out of their analysis. What they didn’t realize is that 12% of their products produce over 180% of their profits, and the new additive manufacturing process would displace about one-third of those sales.
The company devoted several key managers’ time to its risk management process, a major consulting company advised it, the top management team presented the results to the company’s board of directors, and Coastal reported the results to its shareholders and the SEC in its financial reports. Yet many of the most important elements were missing.
For midsize companies, without the size or diversification to absorb these potentially fatal risks, this is a life-or-death issue.
A better way
The action question is how to integrate a company’s key profit-generating customers, products, and operations—i.e., its profit landscape—into its risk management process.
In previous HBR articles, we described transaction-based profit metrics, an innovative new metric that provides the missing risk heat map element. When companies use transaction-based profit metrics and analytics (creating an all-in P&L for every invoice line), they can quickly see that their customers fall into three broad profit segments: “Profit peaks,” their high-revenue, high-profit customers (typically about 20% of the customers that generate 150% of their profits); “profit drains,” their high-revenue, low profit/loss customers (typically about 30% of the customers that erode about 50% of these profits); and “profit flats,” their low-revenue, low-profit customers that produce minimal profit but consume about 50% of the company’s resources.
This profit segmentation enables you to calculate the precise impact of a risk factor (or strategic opportunity) on your company’s profitability. For example, we recently worked with a major distributor that considered its product delivery risk to be very low.
The executive team saw that the company’s revenues were stable, but its profit was dropping steadily, so they instituted new transaction-based profit metrics. They were astonished to find that many of their profit peak customers were fleeing the company. When the team investigated, they found that they were leaving because of poor delivery service. This was puzzling because their regular company-wide customer satisfaction surveys gave delivery very high marks.
A closer look revealed that many profit peak customers were happy with the company, while another group was chronically upset. The difference was that the happy customers were located near a distribution center, while the others were located on the outskirts of the distribution centers’ serving areas. The team learned that the nearby customers were served by the company’s trucks, while the distant customers were served by third-party carriers. The source of the problem was that those carriers had chronic turnover.
Because their customer service surveys had aggregated all customers and the distant profit peak customers were only 3% of the customers (but 35% of the profits), these average metrics vastly underestimated the magnitude and urgency of the problem.
In response, the team instituted special delivery routes specifically for the profit peak customers and developed valuable, high-service measures like off-hours expedited deliveries. The payoff in terms of profit peak customer retention and growth made the investment worthwhile.
Without the profit segmentation generated by transaction-based profit metrics, the company’s traditional risk heat maps were blind to the actual profit impact.
We live in an era of increasingly diverse, fragmented markets, in which various market segments have different pricing, cost to serve, and profitability. The starting point for risk analysis today is your profit landscape, not your potential risks.
If 20% of your customers and products generate 150% or more of your profits, the most important risk management issue is protecting and growing those profit peaks. The core of the risk management process must be a careful analysis of which customers and products are in this segment and what currents of change would endanger or enhance their performance. Close ongoing monitoring of each profit peak customer’s and product’s profit erosion or growth is essential, along with careful periodic scanning for external or internal threats specific to their performance.
The next step is to examine your profit drains and monitor them to see if their losses are growing or diminishing. If they’re growing, you need to develop risk mitigation measures to reverse the trend or think carefully about repricing the relationships to compensatory levels.
Your profit flats are numerous and have low profit per customer or product. Risk factors that affect them are nearly inconsequential to your overall profit production, unless they have a massive impact on large numbers of these customers. However, you need to understand which of these can become your next profit peaks.
In essence, this changes the traditional analog assessment of broadly focused risk management to a digitally detailed risk assessment focused on your contours of profitability. This makes your risk assessment more actionable, comprehensive, and quantifiable.
Most of a company’s key business elements—stores, branches, sales reps, products, suppliers, etc.—form the same profit segmentation pattern, allowing you to replace your risk heat map with a profit heat map that displays profit-erosion risk clearly and comprehensively.
The most useful configuration for risk management is what we call a “profit contour”: a matrix that has the customer profit segments on the vertical axis and the product profit segments on the horizontal. You can easily develop similar profit contours for stores and products, sales reps and customers, and other important combinations.
For example, Austin Associates (not its real name) has about 40 stores with over 120,000 products. Its management team focused its risk management process on four product-store profit segments, with each having its own risk analysis and management game plan. (See the following figure.)
Clockwise from the top right:
Profit peak product categories in profit peak sales stores. These high-profit categories in Austin’s high-profit stores generate about $350 million in revenues and $44 million in profits. The most important company objective is to focus the company’s resources on monitoring and growing this profit segment, as it’s the fastest path to increased profits, and to carefully analyze and react to any risks on the horizon as soon as they arise.
Profit peak product categories in profit drain and profit flat stores. In Austin’s low-profit stores, the high-profit product categories generate $175 million in revenues and $14 million in profits. This profit segment produces moderate revenues and moderate profits. The business objective is to grow the high-profit products while shifting resources away from the low-payoff products and monitoring for risks that would endanger this profit flow.
Profit drain and profit flat product categories in profit drain and profit flat stores. In these low-profit stores, lagging product categories contribute $120 million in revenues but lose $5 million. The prime objective is to redeploy resources to increase the company’s profit peaks. Close risk management at the expense of carefully monitoring the profit peaks is counterproductive.
Profit drain and profit flat product categories in profit peak stores. The group of lagging categories in these high-profit stores contributes about $410 million in revenues but only $6 million in profits. The objective is to aggressively manage the product mix to increase the share of the high-profit products while steering marketing resources toward the higher-profit products. Here, close risk monitoring is less essential.
A Closer Look
When the team saw these striking results, they decided to supplement their analysis by drilling down along a third dimension—their highest-profit customers versus their lowest-profit customers:
Profit peak customers and prospects: This group of customers generates a very strong $460 million in revenues and $97 million in profits. Importantly, even the low-profit products bought by these premier customers produce strong profits. This group of customers overlaps with all the product-store segments above. The objective is to dramatically shift company resources to grow this customer segment. It’s the company’s fastest and most certain path to profit growth, and it requires constant, careful risk monitoring and avoidance. The company needs to immediately respond to any erosion in this profit river. Profit drain and profit flat customers. This group of customers is a major profit drain that warrants intensive focus. It generates $450 million in revenues but loses $40 million. The primary objective is to shift resources away from this group and redeploy them to grow the profit peak customers. The primary risk is inadvertently soliciting customers who will wind up in this segment.
Key to Success
Austin’s profit metrics show that, for this company, account selection and management is the highest-leverage process. Reducing store operating costs is almost insignificant relative to choosing and nurturing the right customers. Any risk factor that endangers the protection and growth of profit peak customers must be immediately detected and aggressively managed.
As competitive and industry currents of change develop, managers must integrate their prospective effects into a company’s profit segment objectives. However, in all cases, your profit landscape must be the starting point for risk management. Every company’s profit segments are different from one another, and each segment requires a very different set of objectives, activities, resources, and risk management priorities and activities.
For midsize companies, with tight resources and the need to focus their competitive positioning on the most lucrative, defensible market segments, this will make all the difference in the near term and for years into the future.