Profitability Improvement Through Profit Mapping
by
Brian Chang
B.S. Electrical and Computer Engineering, University of Washington, 2004
Submitted to the MIT Sloan School of Management and the Electrical Engineering and Computer Science
in Partial Fulfillment of the Requirements for the Degrees of
Master of Business Administration
and
Master of Science in Electrical Engineering and Computer Science
MASSACHU
In conjunction with the Leaders for Global Operations Program at
the
Massachusetts Institute of Technology
JUN 1-8 2014
June 2014
LIBR)ARIES
0 2014 Brian Chang. All rights reserved.
The author hereby grants to MIT permission to reproduce and to distribute publicly paper and electronic
copies of this thesis document in whole or in part in any medium now known or hereafter.
Signature redacted
Signature of Author
of anagement
Electrical Engineering and Computer Science, MIT Sloan Sc)
.nl Iav 9, 2014
Certified by
_________________Signature
redacted
ucjIhesis Supervisor
G~o
Senior Lecturer, Civil a-4iipironmental Engineering
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Certified by
SuCertified by
Senior
Jonatp L.~Bynies, Thesis Supervisor
Engineering Systems Division
Sinaur redacted
_______
Donald Rosenfield, Thesis Reader
Senior Icturer, MiT Sloan School of Management
4:::_
Accepted by
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Graduate Officq, EECS Commit ee on Graduate Students
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Maura Verson, birector of MIT S'n MBA Program
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2
Profitability Improvement Through Profit Mapping
by
Brian Chang
Submitted to the MIT Sloan School of Management and the Department of Electrical Engineering and
Computer Science on May 9, 2014 in Partial Fulfillment of the Requirements for the Degrees of Master of
Business Administration and Master of Science in Electrical Engineering and Computer Science.
Abstract
Faced with a dynamically changing market, Boston Scientific's Cardiac Rhythm Management is seeking
ways to increase its profitability. The division is experiencing a phenomenon where pulse generators and
leads' product life cycle transitions may be slower than ideal. In addition, Boston Scientific is exploring
ways to systematically and accurately assess its products' return on investments.
The approach to the project is a technique called Profit Mapping. By carefully assessing the true full costs
of each transaction, we can determine the actual profitability of each account and product and use the
visualized results to detect anomalies, test hypotheses, and formulate action plans.
The profit mapping tool allows us to compare profitability within each dimension of the businessindividual product, account, sales person, territory, contract group, therapy system, or any combination of
multiple dimensions. When we group data by accounts, we discover accounts that generate much higher
profit than accounts that have higher revenue. Profit Map also shows some products or therapies
traditionally believed to be unprofitable are actually high profit earners. Furthermore, time analysis of
account profit maps revealed accounts whose revenue has been on the decline but profit on the rise thanks
to transition in product mix.
The delivery of the framework and its methodology concludes my internship but is only the beginning of
Boston Scientific's journey to increase profitability. The Finance Department can now combine Profit
Mapping data with the Sales Operations Department's experience and instincts to identify best practices
that contribute towards higher revenue dollar efficiency, re-align sales incentives with company's
profitability, and re-evaluate the opportunity cost of maintaining a marginal or net-loss account/product. In
the long run, Profit Mapping can be scaled up to analyze world-wide data from all divisions to provide a
clearer path to profitability.
Thesis Supervisor: George Kocur
Title: Senior Lecturer, Civil and Environmental Engineering
Thesis Supervisor: Jonathan L. Byrnes
Title: Senior Lecturer, Engineering Systems Division
3
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4
Acknowledgments
I would like to thank the following people and organizations for making my time at MIT an exceptional
experience.
First of all, I wish to thank MIT's Leaders for Global Operations program for its support of this work.
I would also like to thank Boston Scientific for providing me the internship and the opportunity to learn
from its talents. My internship at Boston Scientific is its first project working with the LGO program, so I
am especially grateful that Boston Scientific is willing to take a chance with me. I certainly hope that the
internship has generated some value for both sides, and that Boston Scientific chooses to continue
partnering with LGO's many qualified talents on future projects. I want to give special thanks to my
project champion, Steve Schiveley, project supervisor, Mark Powers, and my mentor, Alex Shrom, for all
the support in lending their time and resources towards the success of the project. Without them, my
project at Boston Scientific would not have been as enjoyable and exciting as it has been.
I want to thank my MIT faculty advisors, Dr. Jonathan Byrnes and Dr. George Kocur. They provided
enormous help in shaping and guiding the direction of the project at Boston Scientific. The majority of
my work was based on the profit mapping technique described in Dr. Byrnes' book, "Islands of Profit in a
Sea of Red Ink." They have gone out of their way to ensure my time at Boston Scientific was both
valuable to the company and my education, and I am thankful of that.
Most importantly, I want to thank my family for being supportive of my participation in the MIT LOG
Program. And a special thanks to my wife, Tracie, for being very supportive of my internship in
Minneapolis while she is pregnant in Boston. I am glad that you can share my happiness. My education at
MIT has been most rewarding, and I wish to share my exciting future with you.
5
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6
Table of Contents
A bstrac t ......................................................................................................................................................... 3
Acknowledgments ......................................................................................................................................... 5
Table of Contents .......................................................................................................................................... 7
List of Figures ............................................................................................................................................. 10
List of Tables .............................................................................................................................................. I I
G lo ssary ...................................................................................................................................................... 12
1
2
3
Introduction ......................................................................................................................................... 13
1.1
Problem Statement ...................................................................................................................... 13
1.2
The Hypothesis ........................................................................................................................... 13
Background ......................................................................................................................................... 14
2.1
Cardiac Rhythm M anagement Therapies .................................................................................... 14
2.2
Boston Scientific's CRM Division ............................................................................................. 15
2.3
Profit M apping ............................................................................................................................ 15
2.3.1
Profit Map M odel ................................................................................................................ 15
2.3.2
Profit Levers ........................................................................................................................ 17
2.3.3
Profitability M anagement Process ...................................................................................... 18
Profit M ap ........................................................................................................................................... 19
3.1
Profitability Database .................................................................................................................. 19
7
3.1.1
Cost Assignment Philosophy .............................................................................................. 20
3.1.2
Scope for Data Gathering .................................................................................................... 21
3.1.3
Invoices ............................................................................................................................... 22
3.1.4
Cost of Goods Sold ............................................................................................................. 23
3.1.5
Selling Cost ......................................................................................................................... 23
3.1.6
Research & Development Cost ........................................................................................... 27
3.1.7
Period Expense .................................................................................................................... 29
3.1.8
Distribution ......................................................................................................................... 29
3.1.9
Administration and Others .................................................................................................. 30
3.2
Profit Map Configuration ............................................................................................................ 30
3.2.1
X and Y Metrics .................................................................................................................. 31
3.2.2
Aggregator/s ........................................................................................................................ 33
3.2.3
Filter .................................................................................................................................... 33
3.2.4
Metrics Table ...................................................................................................................... 33
3.3
Technical Challenges .................................................................................................................. 34
3.3.1
Automated vs M anual W ork ............................................................................................... 34
3.3.2
Moving Averages ................................................................................................................ 36
3.3.3
Returns ................................................................................................................................ 38
8
4
5
Profit Levers ........................................................................................................................................ 40
4.1
Aggregate by Customer .............................................................................................................. 40
4.2
Aggregate by Customer and Therapy ......................................................................................... 45
4.3
Aggregate by Product Category .................................................................................................. 48
4.4
Trend Analysis ............................................................................................................................ 48
Conclusions and Recommendations ................................................................................................... 50
5.1
Strategy ....................................................................................................................................... 50
5 .2
P e op le .......................................................................................................................................... 5 1
5.3
Structure ...................................................................................................................................... 51
5.4
Process ........................................................................................................................................ 52
5.4.1
Generate/Review Profitability Initiatives ............................................................................ 52
5.4.2
Account/Product/Supplier M anagement ............................................................................. 52
5.5
Reward ........................................................................................................................................ 54
5.6
Conclusion .................................................................................................................................. 55
Bibliography ............................................................................................................................................... 56
9
List of Figures
Figure 1: Profit M ap Overview Example................................................................................................
Figure 3: Stage
-
17
Build Profitability Database.........................................................................................20
Figure 4: Stage 2 - Profit M ap Configuration ........................................................................................
31
Figure 5: Profit M ap Configuration U ser Interface...............................................................................
32
Figure 6: M etrics Table Template...............................................................................................................33
Figure 7: Profit M ap by Customers.........................................................................................................
40
Figure 8: Islands of Profit Customers View ...........................................................................................
42
Figure 9: M innows Customer View .......................................................................................................
44
Figure 10: Profit M ap by Customer-Therapy ........................................................................................
45
Figure 11: Islands of Profit Customer-Therapy View.............................................................................
47
10
List of Tables
1: Invoice Colum ns ...........................................................................................................................
22
Table 2: CO G S Lookup Table ....................................................................................................................
23
Table 3: Regional Expense .........................................................................................................................
25
Table 4: Fixed Selling Cost Calculation Exam ple ..................................................................................
26
Table 5: Service Cost Calculation Exam ple ...........................................................................................
27
Table 6: R& D Projects' Product Category and Spending ........................................................................
29
Table 7: R& D per U nit Calculation Exam ple .........................................................................................
29
Table 8: Exponential Sm oothing Exam ple .............................................................................................
37
Table 9: Moving Average vs Exponential Smoothing vs Unsmoothed R&D Costs ...............................
38
Table 11: Custom ers' Profitability Ranking by Q uarters .......................................................................
49
Table
11
Glossary
CRM - Cardiac Rhythm Management
GPO - Group Purchasing Organization
Brady - Bradycardia
Tachy - Tachycardia
HF - Heart Failure
CRT-P - Cardiac Resynchronization Therapy Pacemaker
CRT-D - Cardiac Resynchronization Therapy Defibrillator
LDS - Lead Delivery System
COGS - Cost of Goods Sold
R&D - Research and Development
SKU - Stock Keeping Unit
AD - Area Director
RM - Regional Manager
FSR - Field Sales Rep
FCR - Field Clinical Rep
OR - Operating Room
EAI - Enterprise Application Integration
ETL - Extract-Transform-Load
CPO - Chief Profitability Officer
12
1
1.1
Introduction
Problem Statement
Boston Scientific's Cardiac Rhythm Management (CRM) Division is seeking ways to combat
downward pressure on its profitability. The pressure it faces comes from two directions: fiercer
competition and stronger buying power by large group purchasing organizations (GPOs). Boston
Scientific's CRM Division has been experiencing more competition domestically and abroad from its two
main competitors: St. Jude Medical and Medtronic. The commoditization process creates a downward
pressure on the average sales price of the products, and the fight for market share gives large group
purchasing organizations more buying power to negotiate even lower prices. How to maintain or even
raise profitability in the face of 3-5% annual price erosion becomes the CRM Division's priority.
1.2
The Hypothesis
Boston Scientific's CRM Division is taking numerous measures to raise profitability, including
cost cutting, innovating superior products, and others. One of the measures being explored is Profit
Mapping, a technique developed by Dr. Jonathan L. Byrnes, to help businesses (1) identify their sweet
spots (high profits) and focus their resources on securing and maximizing that part of the business; and
(2) find ways to improve the profitability of other parts of the organization. The technique has proven to
be effective in different industries, geographies, and sizes of the business. The hypothesis of this thesis is
that Profit Mapping can be used at Boston Scientific as a tool to test assumptions, discover root causes of
symptoms, identify misalignments in incentives, and evaluate and improve business with the right
metrics.
13
2
2.1
Background
Cardiac Rhythm Management Therapies
Cardiac Rhythm Management therapies aim at treating cardiac dysrhythmia, conditions in which
the heart rate is too fast, too slow, or irregular. The most common cardiac dysrhythmia conditions are:
bradycardia (brady), tachycardia (tachy), heart failure (HF), and/or any combination of them.
Bradycardia is the condition where the patient's resting heart rate is below 60 beats per second.
Most brady patients receive a pacemaker system implant that helps regulate the heartbeat. These surgical
procedures usually take less than an hour. Pathological tachycardia is the condition where the heart enters
a state of uncoordinated rhythm, or fibrillation, often measured as a resting heart rate in excess of 100
beats/minute. Patients exhibiting indications which suggest such a heart condition are often prescribed an
implantable defibrillator system. When the patient enters tachycardia, the defibrillator will take less than
30 seconds to charge the capacitor and release an electric shock to the heart, resetting the heart to normal.
Patients who have both tachy and brady only need the defibrillator implant as it is also capable of
regulating heartbeat. Heart failure, in the context of this thesis, describes a chronic symptom where one
ventricle overworks and enlarges over the years, eventually leading to fatality. HF patients are treated
with either a Cardiac Resynchronization Therapy Pacemaker (CRT-P) system or Cardiac
Resynchronization Therapy Defibrillator (CRT-D) system.
Regardless of which therapy a patient receives, a system will consist of three components: the
pulse generator, the leads, and the lead delivery system. The pulse generator is a hermetically sealed can
that contains the battery, computer chip, and capacitor (for defibrillators) that regulates the heartbeat. The
leads are the wires that connect the pulse generator and the heart and transfer the electric signals. Finally,
the lead delivery system (LDS) are the specialized accessories that aid surgeons in delivering the leads
through the veins to the heart. In addition, an optional communication device, Latitude, can be installed in
a patient's bedroom to provide more convenient and closer monitoring of the patient and the device's
14
conditions. Latitude can regularly collect the implanted device's data wirelessly and transmit this
information back to Boston Scientific's database, which can be accessed by the patients' health care team.
2.2
Boston Scientific's CRM Division
The CRM Division is one of the core businesses at Boston Scientific with an annual revenue close
to two billion dollars, making up more than a quarter of Boston Scientific's total revenue. The CRM
Division is based in Arden Hills, Minnesota.
Boston Scientific's Operations Division has three facilities worldwide responsible for the
manufacturing and logistics of the CRM systems. The facility in Dorado, Puerto Rico, manufactures most
of the leads; the plant in St. Paul, Minnesota, manufactures the subassemblies for the leads and PGs; and
the facility in Clonmel, Ireland, manufactures the PGs and performs testing and packaging. Clonmel's
facility also serves as the distribution center for non-US markets, while the US market is being fulfilled
from the distribution center in Arden Hills.
2.3
Profit Mapping
Profit Mapping is a technique developed by Professor Jonathan L. Byrnes. It has three major
components: profit map model, profit levers, and profitability management process. Profit map identifies
the company's profit landscape on a very granular basis; profit levers generate recommendations and
action plans; and profitability management process keeps track of the implementation and the continuous
improvement of profitability. Profit mapping is incomplete without any of these three elements.
2.3.1
Profit Map Model
A profit map is a visualization of where the company's revenue dollars are coming from and where
the profit dollars are coming from. In a typical company, most of the revenues are generated by a small
subset of the entire business, be it customer, product, or sales force, and most of the profits are also
generated by a small subset of the business. However, many companies compensate their sales force
based on revenue numbers instead of actual profit to the company. That is why we need a picture that can
15
identify which parts of the business are the bread and butter that bring in large revenue and large profit,
which ones are small fish with low revenue and low or negative profit, which parts of the business do we
under-compensate, and which ones we over-compensate.
Profit maps are generated with a backend profitability database and a frontend visualizer. The
profitability database needs to show revenues and costs at the invoice level because that allows us to
rebuild the financial picture at any higher aggregated level. At the same time, the database needs to reflect
the full cost, as opposed to just the marginal cost, of each transaction. Marginal costs often lead people to
believe parts of the business to be more profitable than they really are. That is why it is necessary to
assign the expenses on the P&L to the invoices. This is a very important refinement of the general
technique of value stream mapping.
The frontend visualizer allows the user to specify the configuration of the profit map, massages the
profitability database, and outputs a profit map (see Figure 1). Let us first establish the definitions for the
key words used in the configuration of a profit map. The profit map illustrated in is built with data from a
subset of the US domestic CRM business, namely the Southern New England and Boston regions. A
profit map can be thought of as a 2-D Pareto chart, with the X-metric being revenue, the Y-metric being
profit, and the aggregatorbeing product category. That means the three product categories in the two
quadrants on the right make up more than 80% of the total revenue in the Southern New England and
Boston regions, and the rest of the 13 product categories on the left make up less than 20% of the total
revenue. The same thing can be said about profit; the aggregates in the top quadrants make up more than
80% of the profit, and the rest make up less than 20% of the profit.
16
Palm Trees
No. of Categories
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Minnows
No. of Categories
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
$
$
$
$
$
$
$
$
$ / Line
Amount % of Total % of Revenue
1
6%
$
38.00
12%
26,944.00
30.00
12%
80% $
21,659.00
7% $
2.00
1,886.00
11%
22.00
59% $
19%
15,780.00
707
Islands of Profit
No. of Categories
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
$ / Line
Coral Reefs
No. of Categories
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Amount % of Total % of Revenue
12
75%
7%
15,308.00
56%
5%
8,513.00
8%
10%
1,467.00
12%
2%
1,795.00
$
$
$
$
4.00
2.00
0.40
0.50
3741
$
$
$
$
$
$
$
$
Amount % of Total % of Revenue
13%
2
62%
137,896.00
85%
65%
116,660.00
7%
55%
9,652.00
41%
70%
57,180.00
905
$ / Line
$
$
$
$
152.00
128.00
10.00
63.00
Amount % of Total % of Revenue
6%
1
$
19%
41,379.00
80% $
18%
33,310.00
11% $
26%
4,551.00
$ / Line
6,998.00
1036
9%
17%
39.00
32.00
4.00
$
6.00
Figure 1: Profit Map Overview Example'
This thesis utilizes Dr. Byrnes' naming convention for the four quadrants. The Islands of Profit
quadrant on the top right are high revenue and high profit aggregates; they are the bread and butter of the
business. The Minnows at the bottom left are low revenue and low profit; these smaller aggregates
sometimes may have strategic value beyond profit dollars, but sometimes may be a drag on the entire
business. The Coral Reefs at the bottom right are aggregates that are high revenue but low profit; this
usually means the aggregates here are not as efficient at earning net profit than their revenue suggests.
The Palm Trees at the top left, on the contrary, are aggregates who didn't make the top 80% revenue but
2
made the top 80% profit; they are the aggregates companies may overlook but want more of.
Each of the quadrants is summarized by a table of customizable metrics. The first column is a
number of metrics the user is interested in. The second column presents the sum of the corresponding
metrics in the quadrant. The third column represents how large each quadrant is as a percentage of the
total business. The fourth and fifth columns are ratios like gross margin, net margin, profit per invoice
line, etc.
2.3.2
Profit Levers
INumbers
2
in the figure are for illustrative purposes only.
Byrnes, Islands of Profit in a Sea of Red Ink.
17
Profit levers are "elements of a company's business model that can be adjusted to improve
profitability," in Dr. Byrnes' words. Prices, service level, lead time, and profit sharing are all examples of
profit levers a company can explore with each customer. This thesis will not go into specific profit levers
to be taken at Boston Scientific but will discuss the ways to explore profit levers in general.'
The optimal profit levers to pull are often very apparent from looking at the profit maps. For
example, a low gross-margin-to-inventory-dollar ratio is an indication that safety stocks are too high.
From there, the company can take a number of actions to reduce inventory: incentivize customers to order
fixed quantity at fixed intervals, pool terminal demands with multi-echelon network, or reduce shipping
time by changing the shipping method.4
2.3.3
Profitability Management Process
Profitability management is the last mile to the success of improving profitability, and arguably the
most difficult stage. In order to successfully manage profitability, top management needs to define its
strategy in terms of profitability and align its people, rewards, processes, and structure with that goal. Just
as andon/Kanban/jidouka are the tools that facilitate continuous improvements in Lean production, profit
map is a tool meant to elicit continuous improvements in profitability.5
3
Ibid.
4 Ibid.
5 Ibid.
18
3
Profit Map
The construction of profit map is a two stage process.
3.1
Profitability Database
The first stage of modeling profit maps is to build a profitability database-a marriage between the
Profit & Loss statement and the invoices database. We begin with querying the invoice database for data
during the period of interest. These invoice lines are the atoms that make up the revenues and tell us
which sales rep sold how many of which product to which customer at what selling price on what day.
Expenses at the same atomic level are usually not always readily available, which is why we carefully
create assignment functions for each of the P&L elements. The P&L statement helps us identify the
biggest buckets of costs and reconcile unaccounted costs for one reason or another. Raw data from
different departments combined with assignment algorithms and assumptions (see Figure 2) tells us the
different buckets of costs at the most granular level-cost of goods sold by SKU, selling cost per PG,
R&D cost by product family, overhead per invoice line, and etc. Importantly, each element is assigned to
each invoice line through a well thought-out function reflecting the nature of the cost. We then augment
the invoice database with costs at the invoice level; now we can reconstruct a picture of the business'
finance from virtually any facet.6
6
Ibid.
19
L;Jk
Invoices
P&L
Algorithms &
Assumptions
Compensation
Structure
R&D Project Expense
Fulfillment Expense
Standard COGS
Accounts' Service
Demand
Profitability
Database
Cost
Allocation
Figure 2: Stage 1 - Build Profitability Database
3.1.1
Cost Assignment Philosophy
The key to a successful profit map is timeliness in profitability database construction, sometimes
at the expense of some accuracy. We must fight the urge to invest too much time and resources in
activity-based costing. A better approach is to iterate on the assumptions and algorithms in the future only
when the cost assignment will change the course of actions. Meanwhile, a 70% accurate profitability
database should already give us enough information on where to look for recommendations.7
It is equally important to not assign costs by revenue for the sake of convenience. Too often we
don't take the trouble to understand and investigate how resources are spent before defaulting to
spreading costs by revenue dollars. Let us take a little detour to illustrate this with the marketing expense
of McDonalds. At first glance it may be tempting to apply a percentage on the revenue as the marketing
expense incurred with the transaction, but we can do better. A reasonable approach is to find the invoices
that match the targeted customers, region, and promotional products of each campaign and spread the cost
of the campaign evenly over those transactions. Again, the idea is not to spend years calculating down to
the penny the amount of costs each invoice line bears, but for categories that are not insignificant to the
7
Ibid.
20
operations of the company, such as marketing to McDonalds, it is worth investing some thought into the
reasonable assumptions and algorithms of cost assignment.'
The categories of costs at the CRM Division are the cost of goods sold (COGS), selling cost,
service cost, research and development (R&D), period expense, distribution, and administration and
others. The COGS is made up of labor, material, scrap, and overhead; one would need to study the
operations and manufacturing process of each product to come up with a reasonable estimate. Selling cost
and service cost would be most accurately obtained from a time-tracking program, but since such a
program is not fully functioning at the point in time of the internship, we will interview the managers to
obtain an estimate. R&D and period expenses can easily be broken into projects, but tying the projects to
the products or product families requires interviewing the R&D Department. For the smaller remaining
buckets, I decided to spread them by revenue with the exception of distribution cost, which is spread by
invoice lines. In hind sight, spreading by invoice lines for administration and other costs is probably
better, as the number of invoice lines correlates directly with the complexity of the business.
It is not uncommon to have multiple iterations of discussions with the stakeholders on the
assumptions and algorithms used for assigning each bucket of cost. I conducted multiple discussions with
different departments within the CRM and Operations Division regarding whether the cost assignments
make intuitive sense and reflect the true cost of doing business before getting the key stakeholders to
agree with the model.
3.1.2
Scope for Data Gathering
We first decide on the time period and geography to gather the data on. We wish to choose a time
period recent enough to reflect the current state most accurately, but the time period needs to be long
enough to minimize the effects of random fluctuation in the data. The time period we choose to analyze is
the first nine months of 2013. As for geography, we wish to study the regions of Southern New England
8 Ibid.
21
and Boston due to the company's familiarity and proximity to the customers in those regions. However,
we do not have the breakdown of P&L statement at the regional level, so we decide to collect the invoices
for the entire US, then later zoom into the two regions for further analysis.
3.1.3
Invoices
The invoices are at the center of what makes up the profitability database. Each column in the
invoice table can become the aggregator when the user configures the profit map. So the more
information we gather at this level, the more configurations of profit map we can explore, the more
powerful the model. The downside is the model becomes more complex and cumbersome to process and
change. Table 1 lists all the columns in the invoice table.
Table 1: Invoice Columns
Column Name
Notes
Month
Customer Name
Name of the healthcare provider
A-
40
Jnzton." tIieeg.YfkAtqt4
GPO
Group purchasing organization's name (e.g. Premier)
Therapy
Which therapy the product is used in (e.g. Tachy, Tachy HF)
Invoice Document Number
Sales Rep Name
Sales Region Name
SaI1u Area N
Qua ntity
Lead Quantity
Note that some of the columns here can be implicitly calculated or looked up from other columns.
For example, quarter and month can be calculated from date; sales area and sales region can be looked up
22
from other tables with sales territory. We still choose to include these columns for convenience in the
profit map configuration stage.
3.1.4
Cost of Goods Sold
A good proxy for COGS is the standard cost and is accessible from SAP at Boston Scientific. The
standard cost of a product has four components: material, labor, scrap, and overhead. The standard
material and labor cost can be computed from materials consumed and total labor hours on the line; scrap
cost are wastages spread over the produced units; and overhead are building, utilities, and etc. spread
across the products and units. Generally speaking, the amount of overhead a product bears is a function of
the material, labor, scrap, capacity, utilization, footprint, forecasted volume, and other factors. Every year,
the Operations Division's Finance Department reviews those parameters, adds up the divisional overhead
for producing CRM products, and updates the overhead cost for each stock keeping unit (SKU). Table 2
shows a partial COGS look-up table with illustrative information.
9
Table 2: COGS Lookup Table
Material Number
Material Description Standard Costs
000000-002
Material 2
11.24
000000-004
Material 4
0.01
000000-006
Material 6
12.64
000000-008
Material 8
0.01
000000-010
Material 10
9367.67
000000-012
Material 12
9402.35
000000-014
Material 14
801.17
3.1.5
Selling Cost
9Numbers and names in the table are for illustrative purposes only.
23
Sales organization's expense is one of the largest expense category but hardest to assign at an
invoice level. To better assign selling cost to each invoice line, we interview and shadow a sales rep to
understand the sales organization and sales process.
Boston Scientific CRM Division's US domestic sales force are divided into 9 areas, each headed
by an Area Director (AD). Each area is sub-divided into a number of regions headed by Regional
Managers (RM). Each RM will typically have half a dozen Field Sales Reps (FSR) and half a dozen Field
Clinical Reps (FCR) responsible for the half-a-dozen territories in the region. Both FSRs and FCRs can
do regular patient checkup and participate in implant operations, but FSRs are usually the people making
the sale to the electrophysiologists or whoever is making the purchasing decisions. Consequently, FCRs'
compensation are largely base salary with a small component of regional performance, whereas FSRs
have on average half of their compensation based on their individual sales performance and the other half
base salary.
An FSR typically will have three types of activities on his calendar: cases, patient checkups, and
selling activities. Cases are the scheduled operations where Boston Scientific's products are used in the
procedures. The sales rep goes into the operating room (OR) with the products and the device
programmer to aid the physician for the entire duration of the surgical procedure. Procedures vary in
length depending on the therapy, but the majority takes less than an hour. Selling activities are meetings
with physicians with the objective of leading to a sale. FRSs and FCRs together spend roughly 50% of
their time on cases and selling. The remaining 50% of their time is spent on patient checkups, which
occurs for Boston Scientific patients every three months. Each checkup lasts around fifteen minutes, but
over the lifetime of the device or the patient, the number of checkups, and therefore the amount of hours,
FSRs/FCRs spend doing servicing activities can add up.
There are three types of selling costs going into a sale: commission, fixed selling, and service cost.
Commission is a percentage of the revenue depending on the therapy. The fixed selling is the time that
24
went into making the sale translated into dollar amount. And the service cost is the amount of service time
that will go into future patient checkups as a result of a particular sale. Commission is easy; we simply
multiply the revenue with the commission rate listed in the therapy column. We also assume that all sales
reps have the same commission plan, as that information is not disclosed to us. Fixed selling and service
costs, on the other hand, are quite tricky, as described in the next section.
0
Table 3: Regional Expensel
1000751-CRM
1000751-CRM
1000751-CRM
1000751-CRM
1000751-CRM
1000751 -CRM
1000751 -CRM
1000751 -CRM
1000751 -CRM
1000751 -CRM
1000751 -CRM
1000751-CRM
1000751 -CRM
1000751 -CRM
1000751-CRM
1000751 -CRM
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
Boston
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
1000754-CRM
S
S
S
S
S
S
S
S
S
S
S
S
S
S
New England
New England
New England
New England
New England
New England
New England
New England
New England
New England
New England
New England
New England
New England
FY3
FY13
Jan
F~b
M4ai
$2,808
$2,820
$3,133
Sal - Exempt/Salaried
$292
$215
$443
Employee Operating Expense
$1,348
$1,504
$1,354
Fringe Allocation
$0
$0
Bonus
$0
$2,898
$6,659
$3,569
Commissions
$160
$147
$149
Leased Vehicles - Adj
$0
Career Development - Adj
$0
$0
$0
$9
$0
Meetings
$372
$445
Travel and Business Meals - Adj
$375
$85
$20
HCP Expense - Adj
$28
$0
$0
$0
HCP Other (Actuals and R&E Grants)
$531
$672
$683
Samples + Inv Withdrawals - Adj
$0
$0
Info Systems
$0.
$44
$15
Supplies
$58.
$36
$11
$29
Other Discretionary
$23
$21
$30
IS Service Allocation
$0
$0
$0
$2,736
$3,134
$2,994
Sal - Exempt/Salaried
$549
$432
$358
Employee Operating Expense
$1,504
$1,437'
$1,313
Fringe Allocation
$885
Commissions
$2,453, $10,084
$117
$114
-$531
Leased Vehicles - Adj
$0
$42
Career Development - Adj
$0
$0
$0
$0
Meetings
$405i
$484
$380
Travel and Business Meals - Adj
$93
$89
$66
HCP Expense - Adj
$1,231
$1,112
$1,023
Samples + Inv Withdrawals - Adj
$0
$7
$0
Info Systems
$88
$15
$58
Supplies
$3
$42
Other Discretionary
$9
$26
$20
$32
IS Service Allocation
Table 3 shows the regions' expense by month with illustrative data. For simplicity's sake, we will
assume all categories of expenses besides commission and bonus are non-variable costs. Since the FSRs
10 Numbers and names in the table are for illustrative purposes only.
25
and FCRs spend on average half their time selling and half their time servicing, we boldly assign half of
each month's non-variable cost as fixed selling and the other half service costs. We also assume each of
the FSRs in the same region will bear an equal amount of fixed selling. Finally, we treat each sale of a
system, as approximated by the number of PGs sold, equally time-consuming. Now we have all the
information necessary to calculate the fixed selling cost for each invoice line. We illustrate this with an
example in Table 4. If Joe Smith is one of the five FSRs in region X who sold 10 systems this month, and
region X's non-variable expense this month is $100,000, then Joe will bear one-fifth of half of $100,000,
which is $10,000 in fixed selling, and each PGs he sold will bear one-tenth of that, which is $1,000 in
fixed selling. On the other hand, if Jane, one of 20 FSRs in region Y, sold four systems this month, and
region Y has a $20,000 non-variable regional expense this month, each PGs will bear only $125 in fixed
selling.
Table 4: Fixed Selling Cost Calculation Example"
FSR Name
Region
Non-variable regional expense
FSRs in same region
Systems sold
Fixed selling/PG
$
$
Joe
X
100,000 $
5
10
1,000 $
Jane
Y
20,000
20
4
125
Service cost per case is non-deterministic for various reasons. The remaining life of the
patient/device, where the patients perform the checkups, and the sales reps performing the checkups are
all unknowns ahead of time. Interviews with sales reps reveal that the biggest factor in determining the
service cost of each case is which hospital the case is performed at. The variation in service demand
serves as the primary factor in determining service cost at the invoice level. We have asked the regional
managers in the Southern New England and Boston regions to estimate the service time their teams spent
at each hospital using the most service-demanding hospital as a benchmark. We then normalize the
service demand to reflect the size of the share of service-cost-pie each hospital needs to take on.
"Numbers and names in the table are for illustrative purposes only.
26
Multiplying the total service cost incurred in the respective time period and region with the share of
service demand of each hospital gives us a dollar amount of service cost spent at the hospital. Finally,
dividing the number of PGs sold in the time period into the service cost yields the service cost per PG
sale. The argument against this assignment is assigning service burden generated by yesterday's sales to
devices we are selling today since the business is ongoing. The justification is servicing yesterday's sales
is effectively the cost of doing business today. In other words, if we stop all the servicing of devices sold
earlier, none of the sales would happen today. Though imperfect, this is the closest approximation we can
reasonably come up with given the information. Table 5 shows a partial table for service cost calculation
with illustrative numbers.
Table 5: Service Cost Calculation Example
Quarter
Region
Hospital
2
Service Demand Against Benchmark Service Demand Share
1 CRM S New England B
S New England
..
....
%
1 CRM
D
1 CRM S New England F
3.1.6
Service Cost
PGs Sold
Service Cost / PG
100%
14% $
10,000
49 $
204
5%
1% $
200
100
410
2 $
:$
25%
4% $
1,000
41 $
24
$4
1 CRM
S New England
H
20%
3% $
800
4 $
200
1 CRM
S New England
J
20%
3% $
800
43 $
19
1 CRM
S New England
L
20%
3% $
800
30 $
27
1 CRM
S New England
N
25%
4% $
100
2 $
50
Research & Development Cost
The R&D process has several attributes that make cost assignment difficult: distance from
production, long development cycle, and the magnitude of investment. Most of the R&D projects
underway at Boston Scientific are for products that will not come out in another year or two. In fact, most
of the R&D dollars are concentrated around only a handful of future products. Once the products being
developed go into full-fledged production, the sustaining R&D for it will drop rapidly and stay low for a
few years until the product's next generation is developed.
1
Numbers and names in the table are for illustrative purposes only.
27
There are several possible approaches to assigning each invoice line its R&D cost. Ideally if we
know the total R&D dollars spent over a product's lifecycle along with the product's historic and forecast
sales volumes, we can accurately determine the R&D spent per product per unit. That is unrealistic as we
don't have either number for most products. An alternative approach, which we did not take, is to only
assign R&D dollars spent on on-market products but keep track of off-market product R&D costs. In
other words, most invoice lines will have zero in R&D spending. One downside of this approach is that it
ignores most of the R&D spending costs that occurred in the time period, which is too significant to not
account for and will make the organization look more profitable than it really is. Another problem will
arise in the future; when future products go to market, they will have enormous R&D costs and will
appear uncompetitive against products for which we have zero R&D due to artificial reasons.
The approach we adopt is one similar to assigning service cost. If we think of the development of
the next generation of an existing product as what enables the company to stay in this competitive space,
we can justify assigning future product cost to current sales. We do so by attributing the development cost
of a product or platform to the closest product category it continues. Table 6 shows a partial list of
research projects, their purpose in terms of product category, and the amount of R&D spending in the past
three quarters. Some of the R&D projects are not product-family specific but can still account for a
significant amount of R&D spending, like quality. We sum up the R&D spending of all such projects and
attribute it to product-specific projects proportional to their R&D spending. Take the projects in Table 6
for example, if the R&D spending were $400, $300, $500, $200, and $100, respectively, the $500 from
Quality will be spread to the other projects, and the adjusted R&D spend will become $600, $450, $300,
and $150.
28
13
Table 6: R&D Projects' Product Category and Spending
Product Category R&D Spend R&D Spend Adjusted
25%
20%
Acc
25%
20%
Brady Lead
Project
PF Leads Delivery Systems
PF Atlas Lead Family
PF Quality
PF Cameron Device Family
PF Navigator Lead Family
20%.
25%
20%
Tachy PG
96%
4Flow
To assign each invoice line an R&D cost, we transform the information into an R&D cost per unit
look-up table, as illustrated in Table 7. The leftmost column indicates the aggregated units sold of all
products of the corresponding product category. The body of the table is a mapping of R&D projects to
project categories. The top row, units sold, tells us the sum of the units sold in all the product categories
related to the R&D project. For example, PF Leads Delivery Systems' Units Sold will be the sum of the
units sold of BRADY ACC, BRADY HF ACC, TACHY ACC, and TACHY HF ACC. With the adjusted
R&D spend, the units sold, and the mapping of projects to product categories, we can then arrive at the
R&D spend per unit by each product category. Using the invoice line's product category column, we can
look up the R&D cost attributable to each invoice line.
Table 7: R&D per Unit Calculation Example"'
Units Sold
Units Sold
R&D Spend Adjusted
Product Category\R&D Project
$
Project A
20
1,000.00 $
Project B
100 BRADY PG
200 BRADY HF PG
300
3,000.00 $
Project C
0
1
0
1
3.1.7
R&D/unit
1
-
tubf
620
620.00
$ 11.00
1$1100
A.
1$
Period Expense
Period expense is assigned the same way as R&D except where R&D has dozens of projects,
period expense has three big buckets. These projects and buckets will remain unnamed.
3.1.8
Distribution
Numbers and names in the table are for illustrative purposes only.
1 Numbers and names in the table are for illustrative purposes only.
13
29
Because the cost of losing a sale due to stock out is so high in this industry, Boston Scientific's
sales reps needs a way to ensure close-to-100% service level. The way the CRM Division achieves this
goal is to have a very short lead time from the DC to the sales rep. All orders from the sale are shipped
using FedEx Standard Overnight by default; around 10% of the orders are shipped with FedEx Priority
Overnight; and less than 5% of the orders are shipped with FedEx First Overnight.
The most practical way to assign distribution cost is to treat each unit's distribution cost the same,
regardless of revenue or product category. Though it is possible that some sales reps order FedEx First
Overnight more often than others, which is four times more expensive than FedEx Standard Overnight,
such situations are very rare and the amount of difference is insignificant.
3.1.9
Administration and Others
Administration and others include all other smaller slices of the P&L pie, including inventory re-
evaluation, marketing, inventory charges, variance, and royalties. Due to lack of proper data to assign
each category of cost more accurately, we resort to spreading them across invoice lines by revenue,
although an argument could be made for assigning these costs by transactions (invoice lines).
3.2
Profit Map Configuration
The frontend user interface allows users to configure the different profit maps they wish to explore.
How management can use this interface to uncover profit levers will be covered in the next chapter; we
first study what the tool is capable of. The parameters users can configure in the interface are: X-metric
and Y-metric, filter, aggregator, and metrics table. Once the user finishes configuring the setup and
proceeds to generate the profit map, the Excel macro will transform the profitability database based on the
profit map configuration and output a profit map sheet and four quadrant view sheets (see Figure 3).
30
* Profit Map Configuration
* X-Metric, Y-Metric
* Filter
* Aggregator
* Metrics Table
Profitability
Database
A
Profit Map
Generation
Profit Map
Palm Trees
Islands of Profit
Minnows
Coral Reefs
Figure 3: Stage 2 - Profit Map Configuration
3.2.1
X and Y Metrics
Profit maps typically segment the aggregates along the revenue dimension and the net profit
dimension, but we wish to allow for more versatility of the tool. One of profit map's primary functions is
to point out misalignment between a pseudo performance metric (e.g. revenue) and the real performance
metric (i.e. net profit), so giving the user control over which metrics to segment the aggregates would
enable the user to explore different kinds of metric misalignment. Figure 4 shows the control for
configuring X and Y metrics under "Step 1". Users can either select the metric from the dropdown or type
it in.
31
Step 1. Select X-Metric and Y-Metric
Step 4: Customize Metrics Table
Palm Trees
(Required)
Net Profit
Islands of Profit
(Denominator) (Denominator)
Minnows
IRpvpnus
Coral Reefs
(Required)
Revenue
Step 2. Select Aggregator/s
(Optional)
Revenue
Gross Margin
Commission
Net Profit
Quantity
+
Aggregator: Customer Name
Step 5: Hit the Button
Step 3. Select Filter and Filter Value
(Optional)
Filter on: GPO
Create Profit Map
(Optional)
Value = 'Novation
Figure 4: Profit Map Configuration User Interface
IOij;;ntitv
3.2.2
Aggregator/s
An aggregator is what the tool uses to cluster together the invoice lines. For example, when the
aggregator is "Customer Name," all invoices generated by that customer are grouped together, and we can
compare the revenues of different customers. In Figure 4, "Step 2" shows the control specifying
"Customer Name" as the aggregator. We also add in the option of allowing two aggregators to be joined
together to create more granular aggregates. For example, if we consider each hospital's different
therapies to be different business, we can join the customer name and therapy together. The resulting
profit map will treat, say, hospital A's tachy business metrics separately from hospital A's brady business.
3.2.3
Filter
We give users the control to zoom into a more specific area of the business. In Figure 4's "Step
3," by specifying "GPO" in the filter and "Novation" in the value field, the macro will only analyze
invoice lines whose GPO value is "Novation". Combined with the different aggregators, users can almost
explore an infinite number of profit map configurations. This set of capabilities enables various users to
explore the profitability of their respective business units.
3.2.4
Metrics Table
(Denominator) (Denominator)
uRevenue
No. of [A14ats
C
QuantiC
Figure 5: Metrics Table Template
JiSemi
Quanti
Figure 5 provides a close-up look at the metrics table, which is a template for how to display each
quadrant's metrics to the users. Starting at the top left cell in the table, the "Islands" cell will always
contain the name of the quadrant-Islands of Profit, Coral Reefs, Palm Trees, or Minnows-and that cell
cannot be changed. The "No. of [Aggregates]" cell is also not customizable. The macro will grab
aggregator information from the configuration and plug it in place of "[Aggregates]". The next five cells
are the customizable text fields reflecting the names of the metrics on their left. Users first pick the
metrics they wish to display in the "Amount" column using either the dropdown menu or text entry, then
modify the display names of those metrics on the right. The "Amount" column will display the number of
aggregates in the quadrant and the metrics formatted according to the symbol in each cell. A "#" will
instruct the macro to display the raw number; a "$" symbol tells the macro to display the content as dollar
amount; the "%" symbol formats the cell as percentage, and a blank cell means "do not display the
quantity". Next we have the "% of Total" column. It will always display each metric in the quadrant as a
percentage of all four quadrants' such metric combined. For example, if there are a total of 40 customers,
and four of them are the Island customers, then the % of Total cell will display 10%. The two columns on
the right are customizable ratios with the denominator metric selectable from the dropdown fields; the
headers are customizable as well, of course.
Users now can configure the profit map of interest and hit the "Create Profit Map" button and
begin analyzing the results.
3.3
Technical Challenges
Neither the backend database nor the frontend interface is without limitations by any means.
Updating the profitability database is anything but a push of a button; there is huge room for refining the
assignment algorithms for categories like R&D and period expense, and corner cases result in profit maps
that are uninformative. We now discuss some of these deficiencies in more detail.
3.3.1
Automated vs Manual Work
34
The process for creating the profitability database is a very manual-heavy work for several
reasons. First, sales and costs data come from multiple systems; secondly, cost assignment assumptions
and algorithms sometimes require interviewing the right stakeholders from different departments; lastly,
when numbers don't add up, we need to manually reconcile the differences and proactively look for error
in data.
Currently, data come from at least three separate sources. Invoice data come from a web interface
that outputs data in spreadsheets; R&D cost breakdown comes from a standalone tool; and COGS come
from the SAP client. There are technologies for integrating data from different sources such as Enterprise
Application Integration (EAI), Extract-Transform-Load (ETL), and other web services.
EAI, also known as Enterprise Information Integration, is a middleware that connects the
different applications and databases and provides a unified view of the organization's data. EAIs have the
advantage of providing instantaneous updates to the profit maps, which is a crucial in the success of
profitability management process, which we will discuss later in chapter 5. However, EAI solutions do
not come free; the time and money it takes to implement goes up quadratically with the number of
applications to be integrated. Fortunately, in this case, we only have three to four applications to integrate.
15 16 17 18 19 20
Another popular approach to data integration is the Extract-Transform-Load process. As its name
suggests, the process extracts data from outside sources, transform the data to fit operational needs, and
finally loads the data into a target database. Unlike EAI, ETL does not require a full-blown integration
between all applications; instead, the companies can selectively extract, transform, and load information
15
16
'?
18
Bernstein and Haas, "Information Integration in the Enterprise."
Gable, "Enterprise Application Integration."
Linthicum, EnterpriseApplication Integration/ David S. Linthicum.
Ruh, Maginnis, and Brown, Enterprise Application Integration[electronicResource].
19 Yongzhuang LiI and Chunfeng Yel, "The Research on the Integration Enterprises Application Architecture Based
on the Web Services."
20 "Avoiding Pitfalls of Integration Competency Centers."
35
as needed. This approach takes less time and resources to implement than EAI but is sufficient for the
purpose of generating profit maps.2'
22
23
There are also data that cannot be extracted from any application or database, such as cost
allocation assumptions and algorithms that can only be obtained from interviews. The service burden of
each hospital is a prime example. In the distant future, when the system keeps track of every sales rep's
time spent at each hospital and how researchers split their time between R&D projects, automatic cost
assignment may be possible, or experienced-based general cost functions could be developed. But for
now, manual assignment of costs is still the most convenient and preferred method.
Lastly, it is important to do a sanity check on whether the numbers make sense after pasting
numbers into formula. I worked with people from finance and sales operations to sample some of the
entries in the database just to see if any number is drastically out of line. Data is correct most of the time,
and we find explanations for what may seem like outliers. However, there are also occasions where
numbers don't add up due to missing data, in which case we must make educated guesses.
3.3.2
Moving Averages
We now revisit the R&D cost allocation with a focus on the sporadic nature of R&D spending. In
the CRM industry, we often see a huge spike of R&D investment in a product family for a few quarters
followed by a drought for an even longer period. For that reason, we choose to smooth out the R&D
spending with past quarters using moving average. Here we will discuss the difference between moving
average, exponential smoothing, and unsmoothed R&D costs. 24
21
Vance, ETL Extract, Transform, Load.
Qin Hanlin, Jin Xianzhen, and Zhang Xianrong, "Research on Extract, Transform and Load(ETL) in Land and
Resources Star Schema Data Warehouse."
23 Betancur-Caldero'n and Moreno-Cadavid, "A Multi-Agent Approach for the Extract-Transform-Load
Process
Support in Data Warehouses."
24 Ick Huhl, Viveros-Aguilera, and Balakrishnan, "Differential Smoothing in the Bivariate Exponentially
Weighted
Moving Average Chart."
22
36
As opposed to allocating the current-quarter spending to current-quarter sales, moving average
allocates an average of the past X quarters of spending to current-quarter sales for each product category,
where X is whatever management deems appropriate. One question that might surface is whether the
moving average R&D spending differs from the current-quarter R&D spending. If the discrepancy is
significant, the company can normalize the moving average R&D spending of each product category to
have them sum up to the current-quarter R&D spending. This approach still keeps the advantage of
smoothing out the bumps across product categories.
However, another concern that still remains is whether R&D spending from recent quarters are
more relevant than past quarters. One answer to this concern is to use the weighted moving average,
where the weight of the information decays linearly with age. One may also consider a more aggressive
technique, exponential moving average, or exponential smoothing, where the weight decays exponentially
with time. In this algorithm, the weight of the most recent period will account for a proportion, a, of the
entire average; the next most recent period will account for a * (1 - a) of the average; the
3 rd
most recent
period will account for a * (1 - a)2 of the average; and the last period will account for the remainder
portion. As illustrated in Table 8, if a is 50%, and the number of periods is four, then the weights of the
four periods will be 50%, 25%, 12.5%, and 12.5% respectively, and the weighted average of 2.125 is
biased towards the most recent period's cost, as designed.
Table 8: Exponential Smoothing Example
a= 50%
Most recent
2nd most recent
3rd most recent
14th most recent
1.5
50%
25%
2
12.50%
1
0
12.50%
Sum
3
0.5
0.125
0
2.125
We now compare the moving average, exponential smoothing, and unsmoothed R&D costs for
the product categories, as shown in Table 9. For confidentiality reason, the actual product category names
37
are disguised with letters. We also normalized the R&D cost per unit to compare against the moving
average data. We notice that the difference in R&D cost can vary up to three times between moving
average and unsmoothed data, while exponential smoothing data is somewhere in between. However, the
table does not reveal the fact that most of the product categories that have huge deviation from the
moving average are categories that have both lower volume and lower R&D spend to begin with. The
core product categories' R&D cost are relatively stable.
Table 9: Moving Average vs Exponential Smoothing vs Unsmoothed R&D Costs 25
PrdcCaegr
(Mvig
r
g
(Epoenia
Smohig
':1
smo
B
100%
118%
130%
E
D
100%
105%
109%
F
100%
211%
285%
H
100%
100%
100%
J
100%
211%
285%
L
100%
211%
285%
N
100%
105%
108%
P
100%
111%
119%
R
100%
100%
100%
Which smoothing technique is applied can influence the R&D cost by a lot in certain cases, but
the actual profit map landscape actually remains relatively unchanged. This is not surprising because the
changes in R&D costs apply to all accounts and all sales reps. Out of the three options, we pick moving
average because we believe it is most representative of the actual recent R&D spending behavior.
3.3.3
2
Returns
Product Category names are disguised with letters for confidentiality reasons.
38
A very difficult problem one encounters when building the profitability database is what to do
with returns. When a product is returned, the company has to refund the revenue, but does it make sense
to credit the costs of distribution?
One extreme is to credit all the costs-COGS, R&D, and even administration. The advantages of
this approach are simplicity and parity. The different categories of costs can be arrived at by multiplying
the quantity sold/returned (positive/negative) by the cost per unit from various lookup tables. More
importantly, a sale and return of the same quantity will cancel each other out, which makes sense if the
two transactions are purely transactional.
On the other hand, a sale and a return of the same product is more costly than doing nothing. The
material may not be reusable, so COGS cannot be refunded, nor is R&D cost refundable; the return of the
product actually costs the company more to bring it in than to ship it out; there is administration cost of
handling the return; there might also be negative implications in terms of customer relationships
associated with the return. To address those concerns, another way to handle return is to assign costs over
the absolute value of transactions. For example, a -$1 ,000 transaction has the same costs as a +$ 1,000
transaction.
26 27
We create two profit maps of the same type, each using one of the two aforementioned methods
of handling returns. The differences between the two profit map's landscapes are negligible and difficult
to detect. A closer examination reveals that returns account for less than 2% of the total transaction
dollars, and are well-spread among the accounts and products. This reaffirms the notion that a 70%accurate profitability database provides relatively informative picture, and that assignment functions
should only be deliberated and refined if they change the profit map landscapes significantly.
26
27
Bower and Maxham III, "Return Shipping Policies of Online Retailers."
Mukhopadhyay and Setaputra, "Return Policy in Product Reuse under Uncertainty."
39
4
Profit Levers
How can managers at Boston Scientific create concrete action plans from profit maps? Below we
share four of the more general observations. Due to the confidential nature of the results, sensitive names
and numbers are hidden.
4.1
Aggregate by Customer
We first investigate a basic profit map by aggregating the data by customer, as shown in Figure 6.
The customers are divided into the four quadrants. Right away we see the 80-20 rule at work here; more
than 80% of the revenue is contributed by 22 out of the 70 customers in the Southern New England and
Boston regions, and most of the net profits are attributable to less than 30% of customers.
Palm Trees
No. of Customers
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Minnows
No. of Customers
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
$
$
$
$
Amount % of Total % of Revenue
0
0%
0%
0%
0%
0%
$ / Line
Islands of Profit
No. of Customers
Margin
Gross
Revenues
Commission
Net Profit
Invoice Lines
0
Amount % of Total % of Revenue
48
69%;
18%
18%
20%
14%
$ / Linel
Coral Reefs
No.
of Customers
Revenues
Gross Margin
Commission
Net Profit
Invoice I ;nes
Amount % of Total % of Revenue
20
29%
$/ Line
76%
7
54
42
Amount %of Total %of Revenue
2,
3%:
$/Line
6
5
5%
4%
Figure 6: Profit Map by Customersn
Figure 7 is a magnified view of the Islands of Profit customers. The vertical y-axis represents the dollars
of revenue. Each column on the horizontal x-axis is represents the revenues and costs contributed by each
customer. The pink bar at the top is sum of net profit, and below it are the various cost elements, totaling
to the revenue from the customer. The customers are ordered from the highest net profit to the left down
28
For confidentiality reasons, some numbers are blacked out.
40
to the lowest net profit to the right. In this view, we see that among the profitable customers, there are still
customers who are generating profit more efficiently than others-customer C has much lower revenue
than customers D and E but trumps them in net profit.
41
Islands of Profit Customers
* Sum of Net Profit
* Sum of Royalties
* Sum of Variance
i Sum of Distribution
* Sum of Inventory Charges
41
C
" Sum of Marketing
U
0 Sum of Inventory Revaluation
* Sum of Admin
* Sum of Period Expense
i Sum of R&D
E Sum of Service Cost
" Sum of Fixed Selling Cost
" Sum of Commission
" Sum of COGS
I C
I
A
B
C
I
D
E
F
G
H
I
J
K
L
M
N
0
P
Q
R
S
Customer Names (Ranked by Net Profit)
2
Figure 7: Islands of Profit Customers View '
29
For confidentiality reasons, the y-axis scales have been removed, and customer names have been replaced by letters.
T
We now turn to the Minnows in Figure 8, where the majority of our customers lie. Same as
before, the vertical axis is revenue with the numbers removed for confidentiality reasons; however, the
scales of the two figures are different-even the highest revenue customer in the Minnows customers
view has lower revenue than the right-most customer in the Islands of Profit customer view. In addition,
this figure includes customers who contribute negative net profits. Here we notice two phenomenon:
customer M17 is an anomaly that stands out, and there are quite a few customers who generate positive
revenue but negative net profit. Customer M17 has an unusually low net margin, high COGS, and high
fixed selling cost. Those are signals that there are opportunities to improve in terms of sales efficiency
and/or product mix. More interestingly, there are a dozen or so customers to whom the CRM loses
money. We don't simply fire those customers. Instead, the sales force needs to first try to bring these
accounts' net profit to positive through selling a different product mix, arranging a different service
model, or other means. If all attempts fail, then it warrants to re-evaluate the strategic value of those
customers and weighing it against the opportunity costs of maintaining them. Often times there are other
low-hanging fruits in the regions to be explored.
A
Minnows Customers
E Sum of Net Profit
8 Sum of Royalties
* Sum of Variance
* Sum of Distribution
0 Sum of Inventory Charges
E Sum of Marketing
N Sum of Inventory Revaluation
C9
* Sum of Admin
E Sum of Period Expense
* Sum of R&D
* Sum of Service Cost
0 Sum of Fixed Selling Cost
* Sum of Commission
r
Ml
*
M3 M5 M7
m Sum of COGS
M9 M11 M13 M15 M17 M19 M21 M24 M26 M28 M30 M32 M34 M36 M38 M40 M42 M44
Customer Names (Ranked by Profit)
Figure 8: Minnows Customer Views
For confidentiality reasons, the y-axis scale has been removed; in addition, the gridlines here have different scales than Figure 8, and customer names have been
replaced by markers.
30
4.2
Aggregate by Customer and Therapy
Figure 9 is a profit map generated by aggregating the data by both customer name and therapy. It
gives us a better resolution to how profitable each therapy is at each hospital. The figure shows that the
Minnows aggregates' ratio of net profit share over revenue share is 11%: 18%, and the ratio for Coral
Reefs is equally bad, at 6%:9%; on the other hand, that ratio of Islands of Profit and Palm Trees are above
par at 81%:73% and 1%:1% respectively.
Palm Trees
No. of Cust:Therapy
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Amount % of Total % of Revenue
2
1%
1%
1%
1%
1%
$ Line
Islands of Profit
No. of Cust:Therapy
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Amount % of Total % of Revenue
24%
44
72%
73%
66%
81%
$ / Line
Minnows
No. of Cust:Therapy,
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Amount % of Total % of Revenue
124
68%
18%
18%
21%
11%
$ Line
Coral Reefs
No. of Cust:Therapy.
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Amount % of Total! % of Revenue
12
7%
9%
8%
11%
6%
$ / Line
3
Figure 9: Profit Map by Customer-Therapy '
Boston Scientific's CRM Division hypothesizes that therapies TI and T2 are more lucrative than
another therapy, T3. According to that hypothesis, we expect to see a lot of TI and T2s in the Islands of
Profit but few T3s. Figures 11 is the magnified view of the Islands of Profit customer-therapy pairs. On
the x-axis, we see the customer-therapies ranked by profit. Note that all but four of the Islands of Profit
customer-therapies are of therapy TI and T2. Moreover, the pair B:T3 ranks relatively high in terms of
revenue but low in terms of net profit compared to the other pairs. These data corroborate with the
division's hypothesis that T3 is generally less lucrative than TI and T2. However, more noteworthy is the
observation that T3 generally has a much more significant portion of service cost across all hospitals
(indicated by the purple bar). This signals an opportunity; if Boston Scientific can reduce the service
demand through customer education and training or transition into charging for service, then a large
1 For confidentiality reasons, some numbers are blacked out.
portion of therapy T3's cost will turn into net profit, possibly out-ranking therapies TI and T2 in terms of
net profit.
46
f4AWN,"
,
1111p;111
q
Islands of Profit Customer:Therapy
" Sum of Net Profit
* Sum of Royalties
* Sum of Variance
" Sum of Distribution
* Sum of Inventory Charges
S
=
£
" Sum of Marketing
S
" Sum of Inventory Revaluation
" Sum of Admin
" Sum of Period Expense
" Sum of R&D
" Sum of Service Cost
" Sum of Fixed Selling Cost
* Sum of Commission
* Sum of COGS
k-
tL
1=
..
..
in k
:
:
I) I
k.
~
In
-i
-X :
i kn
k-
Customer:Therapy (Ranked by Profit)
32
Figure 10: Islands of Profit Customer-Therapy View
" For confidentiality reasons, the y-axis scale has been removed, and the customer and therapy pairs are disguised with letters and numbers.
4.3
Aggregate by Product Category
The profit map aggregated by product category shows a potential misalignment between sales
incentives and the division's performance. We will focus on the Coral Reefs and Palm Trees quadrants in
Figure 12. We know that Palm Tree products are much more profitable than Coral Reefs products, as
indicated by their net profit percentages. In other words, the division would rather see $100 of revenue
from the Palm Tree products than from the Coral Reefs products. However, sales reps are compensated
$11 from selling $100 of Coral Reefs products and only $7 from Palm Tree products. More than a quarter
of the commission expense pie goes to rewarding the sale of Coral Reefs products that generate 9% of
total net profit; only 11% of commission expense went to rewarding the sales that generate almost 20% of
net profit. A remedy to this potential problem is to incorporate net profit generation as a component in the
sales force's compensation structure.
Palm Trees
No. of Categories,
Revenues
Gross Margin
Commission
Amount %of Total % of Revenue $/ Line
6%
12%1
80%
12%
7%
11%
Net Profit
19%
59%
Invoice Lines
Minnows
No. of Categories
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Amount %of Total % of Revenue $/Line
12
75%
7%
5%
8%
56%
E10%
2%
12%
Islands of Profit
No. of Categories
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Amount % of Total %of Revenue $/ Line
13%
2
62%
85%
65%
7%
55%
41%
70%
Coral Reefs
No. of Categories
Revenues
Gross Margin
Commission
Net Profit
Invoice Lines
Amount % of Total %of Revenue $/ Line
1
6%
19%
1
9%,
17%
33
Figure 12: Profit Map by Product Category
4.4
Trend Analysis
We also use the profitability database for trend analysis with any aggregator. Table 10 is an example
of customers' profitability ranking throughout the three quarters. For instance, we see that customer A
ranks 1st in Ql, 27* in Q2, and 8* in Q3 in terms of net profit. The sharp drop between quarter 1 and
33
For confidentiality reasons, some numbers are blacked out.
quarter 2 should raise a red flag. Is our most profitable customer being poached? Or is that just some
periodicity in the order cycle? This is very powerful warning system that helps spot sudden variation or
steady improvements/decline in performance that was previously buried in invoices. Trend analysis
allows management to react to customers shifting away early and discover best-practices among uptrending accounts that can be shared across the division.
Table 10: Customers' Profitability Ranking by QuartersM
Customer Name
A
Q1
Q2
Q3
27
B
C
D
E
F
G
H
K
23
J
L
N
P
R
25
S
T
47
U
V
25
x
24
Y
25
Z
26
14
29
26,
This is only a partial table. For confidentiality reasons, the customer names are disguised with alphabets.
49
5
Conclusions and Recommendations
As seen in the previous section, profit maps can reveal the embedded unprofitable business in each
company and can be used as a tool for both diagnostics and finding treatment to the symptoms of
unprofitability. However, profit mapping should not be treated as a one-off project, but rather an on-going
effort. We recommend companies, including Boston Scientific, to transform themselves into organizations
that embrace profitability management as part of the culture. We will look at how to adopt profitability
management using Galbraith's star model organizational design.35
5.1
Strategy
The strategy behind profit mapping is securing and growing the Islands of Profit business,
improving the profitability of marginal business, and transitioning away from business that is nonstrategic, non-growing, and unprofitable. The strategy may sound simple and self-evident. Why would
any company not want to secure and grow profitable business? Yet all too often we see different
departments act as silos, concerned only with their quota and budget, with little to no regard to how their
decisions impact the company's overall profitability. How does this happen? Typically people equate
maximizing profit as maximizing revenue and minimizing cost, so when management wishes to increase
the bottom-line, the Sales Department would be given a higher quota and the Operations Departments will
be given a lower cost target. Paradoxically, even if all departments meet their targets, there is no
guarantee that profitability will increase. Often, sales reps under quota pressure are incentivized to sell
products in bulk at a discount price that's still profitable less commission and COGS, but when we take
into account all the incremental overhead cost needed to support that sale, we suddenly fall into the red.
The undesired outcome is not any single person's fault but rather the result of a flawed system and the
" Galbraith, Downey, and Kates, Designing Dynamic Organizations.
50
lack of proper infrastructure to promote the desired outcome. To rectify the situation, the company needs
to realign its people, process, reward, and structure with its strategy of hunting for profit.36
5.2
People
The strategy needs to be understood by its people. More specifically, top management needs to
educate middle management of profit mapping, and middle management needs to educate lower
management of profit mapping, so on and so forth. At a minimum, middle management-VPs and
directors-need to gain a deep understanding of how to use profit maps to evaluate their business unit.
This will enable middle management to think about how to improve the overall profitability through
working with other departments. These key stakeholders will form the basis for the profitability
committee, who will ultimately be the ones pushing forward with initiatives and changes.
The strategy should be understood by its external stakeholders-customers and suppliers.
Profitability improvement does not end within the company; it includes maximizing the profit throughout
the supply chain and sharing the profit with customers and suppliers. If companies look close enough,
there are always mutually beneficial opportunities to be taken. That is why it is crucial to work with the
right external stakeholders who are willing to work together to create a bigger pie. We will discuss
account management and supplier management in more detail later.
5.3
Structure
Profitability management requires an interdisciplinary committee of experts from each area of the
company to carry out changes. The members of this "profitability management committee" need not all
be the highest ranking officer of each division/department, but they need to understand profit maps and
profit levers and be able to work with other committee members to affect changes. In addition, the
committee should be headed by an officer with enough altitude and command power to oversee the
process-a Chief Profitability Officer (CPO). Due to the significance and the amount of coordination
36 Byrnes, Islands of Profit in a Sea of Red Ink.
51
required of the role, the CPO is best assumed by the CFO or even the CEO himself/herself. The CPO's
sole duty is to facilitate the profitability committee in generating effective profitability improvement
initiatives and empower them to carry initiatives out successfully.37
5.4
Process
The organization needs to establish two processes: 1) a periodic profitability committee meeting to
generate and review the progress of initiatives, and 2) an account/product/supplier management process.
5.4.1
Generate/Review Profitability Initiatives
In the spirit of continuous improvement, the profitability committee need to meet regularly to
review initiatives in the pipeline and generate upcoming initiatives. The first time the profitability
committee meets, the team can, with the help of profit maps, brainstorm a list of initiatives that can
improve profitability without much capital investment. The committee then triages and prioritizes the
initiatives and selects a few initiatives to act upon. Very often these initiatives will affect and require the
collaboration of multiple disciplines, so it makes sense to assign the initiative to a subcommittee of
related stakeholders. If the initiative's impact and risks are large, the subcommittee may choose to pilot
it at a smaller scale. After successful implementation, the committee can try to generalize the learning
and generate similar initiatives. Rinse and repeat. This process should be formalized as a periodic
routine.
5.4.2
Account/Product/Supplier Management
The other key process is account management. Though it sounds purely a Sales Department's job,
the idea can be generalized and apply to other areas in the company. For now, let's talk in terms of
account management. Account management follows the strategy of: 1) securing and 2) growing the
7Ibid.
52
Islands of Profit business, 3) improving the profitability of marginal business, and 4) retire inherently
unprofitable business.38
The first thing a sales manager has to do, after learning profit mapping, is to lock in his Islands of
Profit accounts with value-added services. The key question the sales people should ask their best
accounts is "what can we do to make our service better?" For example, customer A may want their
orders kitted and has a high willingness to pay; that would be the perfect opportunity to secure customer
loyalty while growing the account.
Another way to grow the Islands of Profit is to identify underpenetrated accounts that share the
same profiles as the Islands of Profit account profiles. Although it seems natural that all the could-beIslands-of-Profit accounts would have already been, the truth is sales reps are too tied up with existing
accounts to explore or reevaluate high-potential accounts. If that's the case, the company needs to
allocate sales capacity to seize new Islands of Profit accounts when they show up or better yet, free up
capacity from unprofitable accounts.
We will not reiterate how to improve marginal accounts' profitability through profit levers but
will address some of the concerns with retiring inherently unprofitable accounts. The fear of losing
revenue, regardless whether the revenue brings profit or loss, stems from both external and internal
pressure to keep revenue high. Realigning the reward system to focus more on the bottom-line rather
than revenue is a great way to deal with internal resistance. The most appropriate way to dealing with
Wall Street is to grow healthy revenue and improve or, if necessary, remove unhealthy revenue at the
same time. Once people see higher return on investment and earnings as benefits of retiring unprofitable
9
business, the process will go much smoother.3
Ibid.
9 Ibid.
38
53
Again, the strategy and philosophy behind the account management process is not particular to
the Sales Department. Just as sales managers grow profitable accounts and retire unprofitable ones,
product development department can also invest in the development of profitable projects and retire
unprofitable projects, and procurement can build a closer relationship with suppliers who bring addedvalues and retire suppliers that eat away profit.
5.5
Reward
Lastly, the company needs to align its reward system with its strategy. The compensation structure
for most companies' sales reps is almost always flawed-sales reps are compensated on and incentivized
to bring in revenue dollars, whereas ideally they should be compensated on and incentivized to bring in
net profit. One may argue that the true profitability of a sale may sometimes be out of the sales rep's
control. In such cases, a compromised solution is hybridize revenue and the company's net profit as the
basis for compensation.
Moreover, the company should change the way sales reps' performance are measured.
Traditionally sales reps performances are measured on how well they achieve the sales forecast targets;
and sales forecast targets are largely based on sales figures from past periods. The problem with this
approach is it ignores both profitability and profit potentials. The profit potential of an account can often
be approximated by the highest profit the company enjoys from accounts that share the same
characteristics minus its own contributed profit. Sophisticated methods of estimating profit potential are
available to be explored as long as it is consistently used for all accounts. A performance metric based on
the sales rep's realized profit versus potential profit levels the playing field, offers sales managers a true
picture of the sales rep's effectiveness, and drive sales reps to hunt for more of the islands of profit."
Usually, changes to the status quo, especially when it involves money, may concern a lot of
stakeholders; this is an important roadblock to changing the reward and measurement system. To mitigate
40
Ibid.
54
such concern, managers need to communicate the roadmap to the end goal and roll out changes in stages.
Aligning people's mentality first will make aligning the reward system much easier.
5.6
Conclusion
Like most other companies, Boston Scientific has huge potential to improve its business and
increase its bottom-line. Building the profit map model is only the start; it is up to the management team
to decide whether to pursue the rest of profitability management. A well-constructed profit map model
combined with a strong profitability management process will lead the company into prosperity. We
sincerely hope that Boston Scientific can continue its great successes to date and begin improving its
profitability through profit mapping that will take the company to the next level.
55
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