How Big Should You Be?

Sizism is an unhealthy prejudice to make business ever larger. It ignores the laws of economics – Pareto, scarce resources, diminishing returns. Yet, it underpins much of the target-setting in business today, as well as reward systems. Through ten simple questions this article shows how sizism can best be understood to the benefit of the CEO endeavouring to ‘rightsize’ business operations.

By Robert Shaw & Susan Goldsmith

Big? Really big? The biggest? Conventional wisdom says big is beautiful. However, is that true? Today, size seems to be viewed as the uncontested success factor in business. Indeed, sometimes it seems like the only factor which is a form of business sizism.

Yet 50 years ago, size was a hotly debated strategic issue, and usually the first factor company strategists would consider. ‘Rightsizing’ a business unit, as it was known, was a serious issue, and this article argues that it should be put back onto the strategic agenda of every business. We begin by examining the fundamental flaws in the ‘big is beautiful’ argument, and then discuss ten rightsizing questions every CEO should ask to find the most successful size of a business.

Fallacies about revenue size and growth

Three sizist fallacies have contributed to the current obsession with growing ever bigger businesses.

The first fallacy comes from cost-volume-profit analysis (CVP), a foundation stone of management accounting. Many accountants behave as if increasing volumes higher and higher will cause profits to rise towards infinity. Accountants seem to forget their

basic economics and the Pareto principle about scarce resources and diminishing returns. In reality, sales volumes are limited and relentlessly pursuing higher volumes will drive up costs disproportionately, as customer needs and wants become satiated.

The second fallacy, which comes from the PIMS studies (Profit Impact of Market Strategy – research study commenced in the 1960’s in General Electric) cited in most strategy textbooks, suggests that, on average, big business units are more profitable than small ones. Here, the fallacy is one of logic, namely by extrapolating from the average to arrive at the universal, thereby concluding that every big business unit is more profitable than every smaller one, and thus growth will always translate into profits.

The third fallacy stems directly from management gurus like Michael Porter and Jagdish Sheth, who claim that firms ‘stuck in the middle’ are financial disasters. Yet, there are very many middle-sized firms that have good financial performance, and there are many giants that are poor performers.

So, if getting bigger is not the answer, what is? Well, there are several questions an inquiring CEO should ask, if he or she would like a more precise answer to how big business units should be.

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By modelling and optimising the customer lifetime value, it was discovered that the company could be much more profitable, if it operated with far fewer customers

ten rightsizing questions every ceo should ask

How many/much?1. Revenue2. Customers3. Innovation4. Globalisation5. Distribution in new channels6. Distribution in existing channels7. Quality8. Pricing9. Promotions10. Marketing communications

1. How much ‘revenue’ should I have? Rightsizing revenues is top priority. Remove revenue targets from staff appraisals and bonuses, unless absolutely essential. Many boards award themselves a salary increase, every time the company gets fatter. Sales directors and their teams, and marketing teams too, are rewarded for ‘pumping up’ volume. Have you ever felt you distrusted your sales chief or the head of marketing? They are probably good people, but their behaviour is likely to be heavily influenced by revenue targets, and they may sacrifice costs and efficiency in the struggle to get higher revenues.

Even shrinking can be a good strategy, if it halts inefficient marketing expenditure. The right revenue level cannot be determined top-down as a matter of principle; it can only be determined bottom-up by answering the remaining nine rightsizing questions, and then adding together the associated revenues.

2. How many ‘customers’ should I have? Rightsizing customer numbers is next on the agenda. In too many organisations sales people are indiscriminately rewarded for new customers, who are ‘collected’ by them, whether they are profitable or not, e.g. bad debtors and late or troublesome payers. In particular, banks and insurance companies exhibit an unhealthy obsession with customer numbers, as they make competing and boastful claims about them in annual reports and shareholder presentations.

Maths can come to the rescue of the CEO in rightsizing the customer base. Get a bright analyst to estimate the cost of acquiring the extra customers, and to make a realistic projection of the profit streams they will generate this year. Add in an allowance for estimated future profit streams, then calculate the net present value. Subtract the cost of acquisition, and you will have an idea whether the customers are worth having. Plot a graph of customer acquisition. It will not be linear, and you will see a turning point after which profits fall. Our conclusion is that CEOs should not treat all customers equally; some will be highly profitable, others losers. Do not let the sales people talk you into treating them as special cases, or believe exaggerated claims of higher profits at some point in the future.

As an example, a major direct marketing retailer had operated for years on the assumption that two million customers was an important target to hit. They

spent over 20 per cent of their revenue on advertising expenditure, keeping new customers flowing through the front door, and maintaining the two-million level. A new CFO arrived and ordered a review of the organisation’s KPIs (Key Performance Indicators) and targets. By modelling and optimising the customer lifetime value, it was discovered that the company could be much more profitable, if it operated with far fewer customers. In fact, nobody could remember where the 2m target came from, and yet nobody had thought to challenge it.

3. How much ‘innovation’ should I have? Rightsizing innovation is next. You can be too innovative, and too much innovation can trigger competitive warfare that is destructive. Of course, CEOs like making claims about innovation - it’s fashionable, it’s fun and it’s often unprofitable. The main pretexts for innovation are growing and protecting revenues. Innovators claim they are the engines of growth, yet all too often what they do is burn costs, with a track record of about 80 per cent failure. Innovators also claim that they protect existing revenues from the threat of new competitor products, but, in truth, it is often cheaper and better to copy a new idea, once it has been tested in the marketplace. Innovators bask in the glory of inventions, yet, after the excitement has died down, and the products fail, the lessons of failure are forgotten, the costs written off, and the cycle repeats itself. Multiple innovation projects co-exist alongside one another, and sometimes

Too much innovation can trigger destructive competitive warfare

get managed on the unscientific principles of funding innovators who shout loudest, or funding the pet projects of senior executives. These are not arguments for stopping innovation altogether, but rather they are arguments for proceeding with caution, and bringing some science and maths into the evaluation of innovation.

Maths can come to the rescue in rightsizing innovation in that innovation forecasting can add rigour and precision to innovation decisions, and there are dozens of methods available such as researching analogues, conjoint analysis and simulated test marketing. Ignoring them on the grounds of forecasting inaccuracy is foolishness; better to be approximately right than precisely wrong. Portfolio analysis is also a powerful tool, bringing objectivity into the subjective world of innovation, and providing the foundation for learning and improvement.

For example, a global drinks company was heavily into innovation. Each year another batch of new drinks landed on the shelves, and the sales people had something new to talk about with customers. Then, a new CFO arrived and asked, “are we innovating too much?” He ordered a portfolio review, with financial and risk models of all the new products in the pipeline. To the surprise of the sales and marketing team, this proved the CFO right. The most profitable activity was selling the existing portfolio, and far too many SKUs (Stock Keeping Units) were launching, when having no chance of

breaking even. They then implemented the portfolio system as a standard procedure, keeping sales and marketing in charge of the innovation budget, but making sure that they had the discipline to spend on brands which earned not burned profits.

4. Which ‘global markets’ should I be in? Rightsizing your geographic footprint makes sense too. Globalisation certainly grabs headlines, which explains its popularity with boards and CEOs. There is something exciting about it, a distraction from the mundane realities of daily routine. It is also a decision trap, bigger even than innovation.

As with innovation, forecasting methods for predicting export growth are now available, which use analogues and parallels to estimate market size, market share and profitability. Portfolio analysis can help get a realistic perspective on global priorities and the importance of China relative to the countries where you currently operate. Scenario planning tools can then estimate up and downside risks. Market entry analysis can estimate the size of the sacrifice in being a late entrant to a market. DCF (Discounted Cash Flow) calculations can put everything into long-term perspective.

A global oil company has filling stations in over 20 countries and set its sights on conquering the Chinese market. Doing so grabbed headlines, but after five years, results were still poor. Management decided to model the optimum resource

allocation across its global markets; the model told them not to invest in China. At first, they wondered if it was short-termism, so they asked the modellers to extend the models first to 10 years, then to 20. Still the model came back and said, “Don’t invest in China, if you want to make profits in the next 20 years”.

5. ‘Distribution in New Channels’ Rightsizing your channels is the next step, starting with new channels. Multi-channel marketing has been a fad now for several years, on the fallacious assumption that, if a new channel opens, you must get in it at any cost. This has been a bad decision for many organisations, and also something of a black hole into which senior executives have kept throwing ‘good money after bad’, fearful of admitting defeat.

During the past decade financial services firms rushed to offer customers an array of internet services, on the flawed assumption that every customer would want to transact on the web. Market research indicated that under 20 per cent of the population actually wanted to do this, but the data was overlooked during the dot.com craze. Prudential was one of the first to take part in this craze, by launching its Egg online bank in 1998 and attracting much publicity. By 2004 the allure was gone, and Egg was put up for sale. It was offered £1 billion, which it turned down. By 2007 a buyer was found, for £575 million, and it was disclosed that in the previous year Egg was running at an operating loss of £145 million.

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6. ‘Distribution in existing channels’ Rightsizing your existing channels is next. This is often a hidden side of growth, but it can be very costly. Adding additional distributors may seem like a good idea, but is it really necessary or profitable to be in every outlet in the market? Yet CEOs on their travels love to see their company wherever they go, and targets of 100 per cent distribution are set.

Maths again comes to the rescue. Channel maps with volume flow rates provide the starting point. In the case of supermarket distribution, shelf planograms are the equivalent mapping tool. Overlay costs of supporting channel relationships, distribution and other services. Estimate the transfer pricing to the channel partners, the costs of distribution deals and listing allowances. Do the sums and you will see the volume-cost-profit graph for penetrating up to 100 per cent of the channel. The curve will not be linear, in fact profits will peak and fall, as you move towards 100 per cent distribution.

A major brewer realised that its product, the market leader, was not available in 60 per cent of pubs and bars. So, it calculated the costs and benefits of increasing distribution by 5 per cent, 10 and so on. To its surprise, it was discovered that its distribution was already optimal, and the cost of accessing the remaining 60 per cent, of small and unattractive bars, was just not worth the extra cost.

7. ‘Quality’ Rightsizing quality has a ring of unreality about it in the wake of the quality revolution. Some CEOs have aimed for quality perfection, supported by the claims of quality gurus. Yet, do customers really

strive for perfection, will perfection at any cost drive up revenues and profits? Is quality the real issue, when the product is outdated or simply boring? Often the quality revolution is about making a substandard product perfectly rather than driving profitable revenues.

The chain store magnate, Chester M Woolworth, decided to sell a higher quality mouse trap through his nationwide empire. It flopped. Customers of the older model tended to dispose of it along with the dead mouse, whereas the high-quality trap was thought too good to throw away, so much so that its customers felt obliged to clean and re-use it. Those who did try the high-quality trap quickly switched back to the original low-quality one.

8. ‘Pricing for profit’ Pricing has been described with some justification as the ‘Cinderella’ of business decision-making. Misunderstood, neglected and misused, pricing is too often used to grow volumes and not profits. Management of pricing is a political fight, in which operations, finance, sales, key accounts and even the chief executive’s partner can throw ideas around, and finally a compromise is reached that defies any logical analysis.

The rightsizing of price levels can benefit enormously from the application of a little maths. All that is needed is information about costs (a given) and rough estimates of price elasticity. The price level that optimises profits drops out of the equations, and the good news is that rough estimates of elasticity are good enough, high levels of precision are not needed. When good data is available, econometric analysis can be used, but

Multi-channel marketing is something of a black hole into which senior executives have kept throwing ‘good money after bad’, fearful of admitting defeat

CEOs on their travels love to see their company wherever they go, and targets of 100 percent distribution are set

Robert ShawDirector, VBMF

Robert is Director of the consultancy VBMF and visiting Professor at Cass Business School. He has provided strategic advice to BP, IBM, Manchester United, Unilever as well as being an advisor to the Chartered Institute of Management Accountants, the Chartered Institute of Marketing and the Chartered institute of Procurement and Supply. He has published over 100 articles and books.

Susan GoldsmithFinance Director, National Express Group Plc

Susan is currently Finance Director of National Express Group Plc, Rail Division. Since qualifying as a Chartered Accountant in 1989, Susan has performed a variety of senior finance roles across the Retail, Media and latterly Transport sectors. A move to Kingfisher Plc followed to take on the role of Director of Investor Relations. Susan subsequently spent four years as Financial Controller of Woolworths Plc, part of the Kingfisher Group. The move to National Express Plc followed five years later.

Contact the authors through ‘My Criticaleye’

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even when the data is poor, judgmental estimates are often good enough.

Budweiser conquered Europe with a canny price strategy. When they arrived from the USA, they priced low and secured massive distribution, around 80 per cent. After a few years at rock bottom, they shot prices up, while at the same time running massive advertising campaigns. The price offensive decelerated growth, but then profits rocketed, making it one of the most valuable brands in the market.

9. ‘Profitable promotions’ If pricing is the Cinderella, then promotions are the Ugly Sisters. Promotions are one of the most misunderstood and misused of all revenue drivers. When demand fluctuates, as it always does and will, scattering a few promotions to customers will start them buying more. In a target-driven revenue world, promotions provide the silver bullet needed to hit targets and win bonuses. Unfortunately, they also destroy profits in eight cases out of ten, but weak accounting and poor record-keeping mean that managers are ignorant of the issue. Often, by manipulating the numbers, it is possible to appear to hit profit targets, in the short-term, by burying or hiding the costs of the promotions, allocating them to future periods or even writing them off, and by raiding advertising budgets.

Mathematical models of marketing mix allocation can help show the true financial picture. These entail simulating the profits and volumes that result from a range of promotional scenarios. ‘What-if ’ analysis and optimisation can help discover the profit-optimal mix of promotions and other elements.

Typhoo Tea saw its advertising spend cut to ribbons under pressure for more and more promotions. BOGOF promotions (Buy One Get One Free) achieved volume spikes of 2000 per cent, but at what cost? Worried about the slippery slope, management commissioned some econometric modelling to quantify the effects. Using the models to play ‘what-if ’ games, the executive team realised that they had let promotions grow too much, and so revised their promotional spend and volume targets downwards, thereby raising profitability.

10. ‘Marketing Communications’ – Advertising, Direct Marketing, etc Rightsizing your communications is important. You can communicate too much with customers, as most customers agree, when they empty their spam filters or put their direct mail unopened into the paper recycling bin. This is not a view shared by most media owners, most agencies, and most marketing directors, who see relentless communication as a business imperative.

A major music company uses TV advertising to sell pop music. Their management spent millions on national advertising campaigns, particularly at weekends. Procurement began to wonder if all this air time was profitable, so they commissioned an econometric study. This disclosed that over half their advertising was wasted, and it pinpointed which half should be cut.

conclusion

Our remedy for sizism is rightsizing. This involves throwing out size targets other than earnings; combating the scams and

rackets of ‘lowballing’, ‘sandbagging’, slack and deliberate waste. It also requires employing some mathematical skills to analyse and optimise the size of the business. Today, such models are being employed successfully in some businesses, and they are growing their business earnings without the inefficiencies of the size-obsessed business.

© Criticaleye 2009