Analysis needs to find explanations for why revenue has followed the path that it has and why the individual cost items have developed as they have.
The previous briefing set out why we need a rigorous causal explanation for what drives profit or other performance outcomes. This analysis does not usually depart from normal practice, at least when it concerns profits, except for the addition of time charts for the revenue and cost items.
Conventionally, revenue would be “explained” in terms of market size and the company’s market share. For the airline example developed in the early chapter:
Revenue = Size of Air Travel Market multiplied by the Firm’s Market Share
This is not, however, a causal explanation so much as an arithmetical observation. It could equally be stated the other way round, i.e. market share = revenues divided by market size. The reality is that customers drive revenue and management activity and decisions aim to win and retain customers.
Similarly, costs are sometimes “explained” in terms of the company’s success in reducing the percentage of revenue expended on each item. So, for example:
staff cost = Revenues multiplied by the percentage of revenue spent on staff
Again, this can equally be expressed another way:
staff-cost-percentage = staff cost divided by revenue multiplied by 100.
While management frequently seek to contain such percentage cost ratios, the reality is that staff numbers drive the cost of staff, and management controls those costs by hiring and firing staff.
To achieve a true explanation for profit over time requires working back from the P&L account along the causal chain until we encounter factors that management can actually influence.
For the airline example that I have been using in this briefing series and in the book, revenue results from the number of passenger journeys sold, multiplied by the average price paid by customers for those journeys. The number of journeys purchased depends, in turn, on the number of customers who use the airline, and the frequency with which they buy tickets. Among those customers will be a substantial number who are regular travellers, as well as less frequent users. There will also be just a few who use it so infrequently that they cannot be regarded as part of the regular customer base, but these are very few in number, and contribute little to the journeys and revenues of the airline.
These relationships are laid out for the low-fare airline Ryanair below (Figure 2.4 form the book). Like most airlines, the company regularly publishes data on “passengers flown”, but the number reported is strictly passenger journeys, not passengers. It is not known, therefore, whether the 34.8 million journeys bought in 2006 came from 17.4 million people travelling on average twice during the year, or from 3.48 million people travelling 10 times each—these two alternatives are not the same, and the difference is important.
- If the first explanation were true, then the company has achieved a very high penetration of all people who may want to travel, and might be advised to focus on persuading them to travel more often.
- If the second explanation is correct, then it has an enthusiastic, if much smaller, band of customers, and would do better to focus on attracting more such people. For understandable reasons, Ryanair does not publish this detail, so the data on journey frequency and passenger numbers in Figure 2.4 are illustrative.
For now, note that the figure introduces a fundamental principle, that:
Customers drive Sales
A similar principle applies in non-commercial situations, even though the focus may not be on financial income. In voluntary organizations, demand is driven by the number of beneficiaries the organization serves. In public services too, there is often some population driving demand for services, whether that be the number of children who need schooling, criminals committing crimes that require policing, or sick people needing healthcare.
Of course, Figure 2.4 is far from complete as an explanation for sales revenue alone. The number of journeys each customer makes each year depends on price, the range of destinations offered, service frequency and quality, and so on, and on how all of these compare with what competitors offer and what customers expect. Lastly, we cannot of course ignore general market conditions entirely. Consumers’ general propensity to travel, the impact of economic conditions on demand, and fundamental changes, such as population growth may also need to be taken into account. But revenue certainly depends on the number of customers.
Note by the way that where firms supply durable products, such as washing machines or cars, sales volume and revenue arise from winning the customer, rather from holding the customer into the future. This point will feature in a future briefing.
If we now look at the cost elements of the P&L account and follow the same approach of rigorously asking ‘what causes what’, it turns out that another universal principle emerges:
Resources drive Costs
For the airline, the major cost drivers are aircraft, the routes and airports operated, and the number of staff employed. Generally, the most common costly resources are capacity [in whatever form is relevant for your case], people, and the product-range.
Until next time…
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People are sometimes surprised… that they need to pay so much attention to things – customers – they don’t own or control. But there is a reliability about customers or clients that makes them an integral part of the system. Indeed, customers can be a more reliable – in the sense that they are likely to still be with us next week, next month or next year – than employees who are paid to be there. McDonald’s, for example, can expect its average employee to remain for just a few months, whereas many customers have been loyal users for many years.
Management often comes at the problem of understanding performance from the wrong start-point. One firm I worked with provided specialist equipment and chemicals for the intense cleaning of high-specification industrial components. The management could tell me all about growth prospects for their market sector, and changes they hoped for in their market share, thinking this was the way to estimate future sales. They also told me about their targets for reducing the fraction of sales revenue they would be spending on sales effort and administration, assuming this was the way to estimate future profits. They were encouraged in this approach by the targets set for them by the finance department at corporate HQ.
But the reality was that their sales came from the number of customer using their products, and they had given no thought to what those numbers were, nor the rate at which they might grow them. Nor had they worked out what impact their sales effort had on gains and losses of customers as the basis for working out how many sales people they needed – as opposed to what fraction of revenue should be spent on sales effort.
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