“Business is all about solving people’s problems – at a profit.”
– Paul Marsden, Social Guru
What is this Profit Tree you speak of?
Properly framing a situation is one of the most important things you can do when trying to develop winning strategies. The profit tree is a straightforward tool to help you properly frame your situation. When it comes to profit, are you growing or shrinking? If you are shrinking, is it because of a decline in revenues, an increase in costs, both? If revenues are decreasing, is it because of a decreasing number of customers, or decreasing average sales per customer, or both? The deductive logic can continue down the tree until you get to some of the root levers of what is driving profit dynamics.
In many strategy projects, the profit tree is one of the first tools we use, because it helps a team quickly work with management to diagnose a situation, explore the business, and come up with hypotheses on profit growth opportunities. Most strategy consulting firms use the profit tree, and once you start using it, you’ll quickly understand why.
The profit tree is one of those tools that some people would say, “really, that seems way too basic.” But, it is often the basics that are missed or aren’t properly understood. Probably half of the management teams we’ve worked with don’t even know the direction of the metrics three layers down in their profit tree. It is like a doctor that doesn’t know the full breadth of diagnostic statistics on a patient. Would you really trust that the doctor is going to give you the best treatment?
Just calculating the changes of all the elements of a 3-Layer Profit Tree, from year to year can be incredibly insightful. As an example, if revenue is growing, is it driven by growth in the total number of customers or average sales per customer, or both? If the total number of customers is shrinking, yet revenue is growing due to price increases, the dynamic will be hard to sustain beyond the short-term, and I would question the overall value proposition of the company. If the total number of customers is shrinking, yet revenue growing due to customers purchasing more units and products, while pricing is stable, then that tells me the proposition might be strong, but marketing, sales, and distribution might be an opportunity.
Let’s take the profit tree down one more level and change it a bit to focus on the actions that can grow profit. Here is what it looks like:
Why is the Profit Tree important?
When you’re sick, and you go to the doctor, they try and diagnose what your ailment is, by taking your temperature, prodding and poking you, and asking you a series of questions. When I go into an organization, I need to quickly diagnose their ailments and opportunities. The best tool to start with is the profit tree. I ask simple questions such as, “are revenues increasing or decreasing? Are costs increasing or decreasing; faster or slower than revenue? Is revenue growth because of a growth in customers or a growth in sales per customers, or both? What are the drivers of variable costs; more products sold, shrinking gross margins, logistics costs, service costs?” You can quickly diagnose potential issues and areas that need to be further investigated by systematically going through the profit tree and answering these types of structured questions.
How do I grow my Profit Tree?
For the strategic leader, a profit tree is typically used as a diagnostic tool and as a framework to organize ideas. Here are some of the best uses and practices of profit trees:
Create your Profit Tree
Your organization’s profit tree might look slightly different than the one presented. Maybe you don’t have access to the number of customers and average revenue per customer. Instead, for revenue maybe you can use the number of products sold and price per product. Maybe you don’t have logistics costs, but instead, implementation costs are a big part of your profit tree. Maybe it is better to split your customers from existing customers and new customers. The key is to create your organization’s profit tree in the language and elements of that fit your organization. And, then collect the necessary data to build the profit tree, and if you can, compare the elements to last year to see how things have changed. While the income statement and accounting system in most organizations typically have the data to build a profit tree, some of it may be difficult to gather, especially the customer data. But, if you can get to it, it is usually packed with insights.
Use it as a Diagnostic Tool
As a diagnostic tool, it is useful to calculate the historical trends of the profit tree branches. When profit is growing or declining, it is always critical to understand what is driving the trend. Is it revenues or costs? If revenues are declining, is it because the number of customers or the spend per customer is declining? If it is the spend per customer, is it because of fewer visits, items per visit, or price per item?
Grow the Weak Limbs
Once you identify weak limbs of the profit tree, either through trend or benchmarking analysis, then it is time to build strategies to grow the weak limbs. For a retailer, we set up their business intelligence that allowed every store to understand their profit tree, and then we trained store management on 40 ways they could grow the various limbs of their store’s profit tree. The example is below.
DOWNLOAD THE PROFIT TREE POWERPOINT WORKSHEET
To get you going on improving profit tree, download the free Profit Tree Improvement PowerPoint Worksheet.