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The Number One Way to Master Making Money in the Solution Provider Business

It is currently fashionable to title an article or a speech with a list: "The Top Eleven Ways to Differentiate Your Company That Everyone Uses," "The Six Ways to Succeed at Anything," "The Five Rules of Growing Your Company Fantastically Fast Using Anti-Gravity."

Fair enough. In the interest of saving you time, we limit ourselves to a list of one.

The Number One Way to Master Making Money in the Solution Provider Business:

  1. Learn P&L management.

I was trained to be an English teacher, and have no natural financial skills. I started in the Solution Provider business in sales and after successfully mastering the basics of that (three President's Clubs in a row), I became fascinated with service management. The chance to make sure clients could benefit from their computers was too good to pass up. I learned how to roll out service offering after service offering to a larger and larger number of branch offices of our growing Solution Provider business.

What does this have to do with P&L management? I noticed that my bosses (who lucky for me turned out to be excellent managers, based on their financial results) would not let me roll out a new service unless we all felt pretty comfortable we would make money doing it. Pretty comfortable, in the sense of: We've built a financial model and if things go moderately well, we'll make decent money. If we weren't comfortable, no new service, no matter how "logical," "elegant," "inevitable," or "in demand" it was. Why? We were in business to make money.

I also noticed that some of our branch managers usually succeeded at adopting and profitably selling each new service, and some of them did not. After travelling around helping them, the pattern became clear: the ones who had a pattern of succeeding understood P&L management. Other things were important: leadership skills, sales and marketing skills, service operations skills. But they could have all three of those and still fail to consistently make money, much less make good money.

I should give you a bit more of the back story before going on to describe P&L management for you.

Some Evidence This is True

When I joined the company, it had 14 locations and $300mm in revenue, of which $5mm was services. Over the next seven years, we grew the company to $2 billion with $350mm in services, about half of which would today be called Managed Services. We grew to about 3,000 billable people.

We also grew to 44 branches, each of which had the management equivalent of an “owner,” that is, a top manager for that geography. We called them “branch managers” and – our business largely being product resale – they largely managed sales people, which was not an easy job. Since the majority of cost in a branch was in the sales team, the branch managers had a good understanding of sales efficiency and effectiveness. They also had a good understanding of product gross margin and vendor programs.

As we added services, we began to see the pattern described above: if the branch manager had P&L skills, they were more likely to succeed at growing a service business.

Why? Offering a service (at least, offering one delivered by your people, as opposed to a re-sold cloud service) puts you in the business of manufacturing. If you will, you “manufacture” the service by procuring raw material (labor) and putting it through a process which turns the raw material into something of higher value, which the customer can more easily consume. As a manufacturer, your risk and potential reward are considerably higher than as a reseller. The added risks are primarily that you will produce a product that will not sell, that you will sell it for a too low price, and/or that it will not be of sufficient quality to keep customers happy.

For this reason, as difficult as sales management is, service management is harder. Doing both together is harder yet. Doing both without consistent cash flow is possible but it is needlessly difficult and perilously risky.

Mitigating the risks of service “manufacturing” requires a number of skills, but the primary one is in understanding how revenue and cost work, that is, in understanding how the P&L works. You can get everything else roughly right, but if you get the financial part only roughly right, you will fail to have predictable, grow-able, safe cash flow.

As we proceeded to grow services much faster than product sales, we found that our branch managers separated themselves into three groups. About 20% of them either had P&L management skills from a past life, or had a knack for it. We gave them a bit of support. About 20% were trainable if they were willing. We gave them a lot of support. About 60% were either not trainable or not willing, even with a great deal of support, and they left the company within about an 18 month period from the time when we identified P&L management skill was a critical success factor.

From then on, when a branch had inconsistent and low financial performance, the diagnosis could contain any number of concerns, but one consistently appeared: the branch manager did not have good P&L management skills. We provided leadership training, sales management training, service management training, but even when they got the first three right, if they did not take to the P&L management training, they generally continued to produce unacceptable results.

Later, in another Solution Provider which was 100% services and about $130mm, I ran one quarter of the company; four of its fourteen branches. The pattern was clear here, too: if the location’s general manager had good P&L skills, it got better and more consistent financial results.

Later still, in one of the first SMB Managed Services firms, I was responsible for buying small Solution Providers. My team searched through thousands of SMB Solution Providers and closely inspected hundreds of candidates, to find the dozens we got into deep discussions with, to close eighteen transactions in about twenty months. Once again, the pattern was evident: the SMB Solution Provider owners who had P&L skills more often had better results, more consistently, over longer periods of time. They typically had bigger companies, too.

Even later, after ten years of consulting with Solution Providers of all Predominant Business Models©, sizes and markets, P&L management skills still stand out as the single best predictor of a Solution Provider owner’s likelihood of generating good cash flow and stock value.

It isn’t that managers who can read a P&L are magically better managers. It’s simply that they have their eyes open. They have much better information, and as a result they make smarter decisions.

The good news is P&L management is a learnable skill. The bad news is, it is hard for most people and it takes time to sink in.

Other good news is, even small and early steps in understanding P&L management can yield substantive, sustainable cash flow improvements.

What is P&L Management?

P&L management is neither bookkeeping nor even accounting. P&L management is the understanding of the sources of financial energy production and drain in your company, and the understanding of how to control them.

P&L management says we set boundaries for acceptable financial performance and take management action to stay within them, as opposed to making operating decisions and seeing (or not paying much attention to) what the financial outcome will be.

In this way, the P&L management method is much like the scientific method: we form a business hypothesis, and then we test it. If it fails the test, we terminate the experiment and try something else. But we don’t start the experiment until we have fully formulated the hypothesis and defined the success criteria.

For example, we want to get into the cloud services business by building our own private cloud. Sure, we might do a bit of reselling others’ cloud services, but primarily we will “manufacture” our own cloud services. This should give us good differentiation and that, combined with being the OEM, should give us great margins.

This is the germ of a hypothesis, but it is not a fully formed one, so we can’t start the experiment (that is, building or selling the cloud service) until we have fully formed the hypothesis.

The fully formed hypothesis looks like this:

But why, if my gut tells me a lot of clients want high quality, differentiated cloud services, would I want to go through this exercise at deeper than a back-of-the-napkin level?

As you formulated your private cloud services hypothesis, your thinking about financial boundaries would lead you to the question, “How much hardware and software will I need to buy or lease, and when, to have the capacity to drive enough revenue to make a profit?”

Since you are an expert in IT operations, you would no doubt understand that your operating costs will be helped by having the most modern equipment.

At this point, your expertise would start to nag you, because you realize that, after about three or four years of growth, your initial equipment would no longer deliver state of the art efficiencies. To stay ahead of the operating cost curve, you need to retool the “factory.”

If your initial investment was “X,” and “X” was offset by revenues sufficient to make a decent profit, you now realize that to pay for the new gear that will be needed in three years, you actually have to sell 25% more each year until then, and bank the difference. This means you need more than “Y” customers, at higher than “Z” prices, or both. That’s because you don’t have unlimited “N” time; you only have three years.

What additional investment will it take to find and win even more customers at perhaps even higher prices? That additional sales and marketing investment itself, will in turn require even more customers at perhaps even higher prices.

Through the process of modeling out these revenues and costs on a spreadsheet, you will find out if there is a sweet spot, or if the whole experiment is too dangerous—before you invest your money in it.

If there is a sweet spot, you will have set the boundaries within which the experiment must operate, or it will be terminated before it blows up the lab or gives the company the financial equivalent of Ebola Virus.

P&L management also enables the setting of boundaries on everyday things, not just new initiatives, and it enables monitoring activities against those boundaries. To wit:

As you can see, even these two simple P&L management rules can precipitate a complex series of alternatives and decisions. Yet if followed to the letter, they also produce gratifyingly high and consistent profits.

Imagine if you followed these two rules without exception. How much easier it would be to run the company! Notice I didn’t say “easy,” but “easier.” The hard part would be figuring out how to do it, but at least you would know you will never stray outside the boundaries of good cash flow, which greatly eases managing all aspects of the business, and greatly offsets a (calculated, planned) risk or two. How much harder it is to make progress when unexpectedly low cash flow occurs!

If you followed these two rules without exception, all your creativity can go into how to stay within them, instead of some or all of your creativity going into how to rescue yourself from emergencies.

A second major benefit of undertaking P&L management is higher stock valuation. This comes in two forms. First, of course, better P&L management generally leads to higher cash flow (EBITDA) which in turn is a key factor in most valuation methods.

The second is that better P&L management generally leads to more consistent financial results (fewer ups and downs). Buyers purchasing anything want to be assured that they will get what they have paid for. Buyers of businesses (or lenders or investors), knowing how risky business is, especially want as much comfort that their investment will not fail. When looking at a company’s past performance, it is greatly reassuring to see smooth sequential growth in revenue and profit, quarter after quarter, year after year. It is greatly discomforting to see swings, and buyers will offset the risk they see in swings by reducing valuation, adding risk for the seller in the deal structure, or both. In many cases, the buyer will simply abandon the transaction, depriving the seller of a strategic option.

Clear indication of this can be seen in the chart below, which shows the 12 most recent quarters of S-L Index™ benchmark results, with all Predominant Business Models© combined for simplicity:

Click to enlarge

Over the 12 quarters of the worst economic times in recent memory, the Best-in-Class Solution Providers (that is, those with top quartile profits) kept profits within an 18% variation from their average profit of 18.7%.

The Median Solution Providers, on the other hand, managed to keep profits within a 60% variation from their average profit of 5.3%. Put another way, their profits were likely to swing three times more dramatically than their Best-in-Class peers. And this swing was against a much lower profit baseline (5.3% vs. 18.7%).

The Bottom ¼ of Solution Providers, it causes one alarm to notice, experienced a variation of 107% against an average loss of 7.8%. This is five times the variation experienced by their Best-in-Class peers, a challenge exacerbated by experiencing negative cash flow at the same time.

Understanding P&L management provides other significant benefits:

P&L management provides the owner/executive with strategic and tactical business advantages unsurpassed by any other skill they may have.

Components of P&L Management

The components of P&L management are straightforward when taken one at a time and bit by bit. It’s important to remember that even small gains in understanding can produce large financial and operational benefits.

Reading a P&L (aka Income Statement)

Reading a P&L is the act of running your eyes down the accounts and, in this sequence:

The act of reading the P&L is often made difficult by the fact that many P&Ls are arranged in ways that do not allow visibility into the things that actually create profit and loss. This is because accounting systems, as they come out of the box, do not “know” the proper arrangement of accounts to effectively diagnose and track the typical profit and loss areas of a Solution Provider business. As a result, many who are new to reading P&Ls become quickly frustrated, lose interest and conclude that reading P&Ls is not a productive activity. This is a shame.

Happily, the Normalized Solution Provider Chart of Accounts© upon which Service Leadership Index® benchmarking is based, is as easy to read as is possible while still providing the detail needed to make useful decisions.

Likewise, for subscribers to The S-L Index™ Quarterly Report Book, that document is essentially laid out as a clear, transparent P&L for a Solution Provider business.
 

Judging a P&L

From reading a P&L to judging the state of the business on which it reports, is a large leap in expertise. That said, there are some simple guidelines which can help you quickly zero in on areas of opportunity or concerns, without being a P&L expert.

There is a great deal more “how to” in the “Getting a Head Start – Using Your S-L Index™  Quarterly Report Book,” but let’s take a look at a few pointers now:

  1. Bottom Line: Is the company making money at the operating income level? If so, then there is a good chance there is not an emergency situation in the company. From there it is a question of degree: in a product-resale-centric Solution Provider business, anything less than about 3% profit is a concern. In a services-centric Solution Provider business, anything less than about 6% is a concern. The degree of concern is judged by the trend – up, down or steady – and other factors.
  2. Regardless of whether the company is losing or making money, the next question is, “Where in the business is this happening?” The Normalized Solution Provider Chart of Accounts is arranged to easily see the gross margins of the major lines of business that exist in Solution Providers. As a result, it is easy to spot underperforming or excelling lines of business.
    1. Generally, product resale gross margin of less than about 14% is a concern. Why? This level of gross margin is low enough that even reasonably well controlled SG&A (operating) expenses could add up to more than the gross margin being generated, resulting in a bottom line loss for the company. Either gross margin needs to be raised, or expenses reduced, or both. Best-in-class product resale gross margin is about 19%, which would result in a 6% bottom line profit if SG&A expenses are in line.
    2. Generally, services gross margin of less than 35% is a concern. This is because the SG&A needed to run services is around 35%, meaning the company is bordering on a loss. Once again, either gross margin must be raised, or SG&A expenses reduced, or both. Best-in-class gross margin for services is about 55%, which would result in a 25% bottom line profit if SG&A expenses are in line (rightfully so, SG&A expenses in a 100% services firm are higher than in a 100% product resale firm).
  3. Now that we have looked at gross margin, the next area to look at is SG&A expenses. Of these, it is important to be able to separate out the Sales (and Marketing) expense. This is because it is usually both a large cost and one that must be closely managed to be productive.
    1. The Sales and Marketing expense in a product-centric company is low – around 2.5% – because the sales cycle is short and much of the lead generation and value proposition communication is done by the manufacturer. It’s good that it is low, since as we have seen, so is gross margin.
    2. The Sales and Marketing expense in a services-centric business is usually in the range of 13% to 14%, because the lead generation and value proposition communication is done by the Solution Provider, since there is no “vendor” for services.
  4. Next we have General and Administrative expense which makes up the balance of SG&A expenses. This is management payroll, administrative payroll, rent, telephone, and a variety of other costs needed to “keep the lights on.”
    1. In a product-centric business, this is usually around 10% of revenue,
    2. In a services-centric business it is generally around 21%, because of the larger office space and additional management and administrative capacity needed to accommodate the services people.

In just a few minutes, we have looked at four areas in the P&L and arrived at some basic conclusions about the business:

We have judged the health of the business, determined the extent to which a celebration or a declaration of emergency is merited, and passed judgment on which parts of the business are contributors and which are drains. (Note: a more detailed version of this discussion is available in the document called “Getting a Head Start – Using Your S-L Index™ Quarterly Report Book.”)

Taking Action on What You See on the P&L

Of course, a P&L is nothing more (and nothing less) than a diagnostic and monitoring tool. As with any such tool, you must develop judgment about what you see, as we discussed above.

You must also take action – and effective action – on what you see. If you don’t, no amount of reading P&Ls or digging into the numbers will be of benefit.

This, of course, is the purpose of peer group membership – to take action to do better. Obviously the Service Leadership Report Book (PDF) – which is simply a P&L with highlighting added to enable quick comparison to best-in-class performance – is your primary diagnostic and monitoring tool.

But the Report Book is something that a P&L is not. Because it compares members to each other and to best-in-class, it can also be used to drive the discovery and validation of best practices within your group. It can also be used to identify who needs what kinds of help.

Here’s how: Pick a single metric, say, for example, Managed Services gross margin.

Beyond Basic P&L Management

We’ve now covered basic P&L management: reading a P&L, judging what is happening, and taking action in your peer groups.

What are the next P&L management skills we might need?

As you can see, learning to read, judge and act on a P&L is a tactical skill which can help you drive more profit and run a safer company right away. In addition, it is a foundational skill upon which succeeding layers of management mastery are built.

P&L management is the business owner/leader’s responsibility to his/her employees and shareholders. It is a powerful tool for producing results.