Good Profits vs. Bad Profits: What You Need to Know As You Grow

“Good” profits are like compound interest or a snowball rolling down a hill. “Bad” profits are like eating your seed corn or spending endowment capital: the results are not immediately apparent, but over time it is an unsustainable situation. For growing businesses, the ability to differentiate between good and bad profits, and generate good profits, is especially important.
So why don’t businesses focus on good profits? One reason is that businesses today are under tremendous pressure to grow, and maintaining growth is hard. For public companies, quarterly reporting can provide a temptation to go for short term gains. As a result “savvy” managers look for any way they can generate a profit today.
Why accounting systems don’t help
Note that bad profits are less the result of doing the “wrong” things than an indication of not doing the “right” things. They’re not the result of illegal, or even unethical, practices. Most businesses generate a combination of good and bad profits, but our financial accounting systems aren’t geared to semantics and can’t perceive the difference between “good” and “bad” profits. As a result, even enlightened managers are hard-pressed to identify bad profits. Was that last dollar “good” profit or “bad” profit?
A few years ago, there was a movement by some businesses to identify “bad” or unprofitable customer segments. Once identified, these customers would be “encouraged” to find another provider, or in some cases, they were “fired.” This is why many banks fail to offer free checking to small depositors. It is not that they fail to see the desires of some customers; it is that they pro-actively do not want to service that segment of the market. The fees are designed to drive off certain types of customers.
Revising the 80/20 rule
“Bad” profits, on the other hand, result when customers don’t perceive excellent value. Since providing world-class service to all types of customers may not be possible, organizations need to figure out how to identify which customers they should be focusing on, and how to get out of the business of serving other customers. Since many businesses generate 80 percent of their profits from 20 percent of their customers, this analysis is not always difficult. To this point, the intent is the same as looking at “good” or “bad” customers, but the lens of “good” or “bad” profits is not concerned with whether the customer generates revenue in excess of costs, but whether those profits are likely to compound or diminish in the future.
If you ever hear someone say, “We can get away with…” with regard to pricing or service levels, any resulting “gains” are almost certainly “bad” profits. Tools such as NetPromoter also exist for aiding or measuring this effort. NetPromoter assumes that customers not singing your praises are a drag on your business. NetPromoter is also focused on diagnosing the causes of customer dissatisfaction rather than pruning away parts of your business where you are less successful.
Deeper customer knowledge is the key
So what to do? Ask yourself why customers do business with your organization. If it is because they “have to,” then that is a good indication that you are living off of bad profits. If, on the other hand, your customers look for new ways to do business with you, that is a good indication that you are able to generate good profits. The trick then becomes separating the generators of good and bad profits, a task that is nearly impossible unless you have a deep understanding of your customers, segments and competitors.
Well-managed businesses will employ both types of tools to ensure they are investing resources in areas of business where they can generate above-average returns, and that customer profits are a gift that keeps on giving. There is nothing counter-intuitive here; 40 years ago Peter Drucker wrote that businesses should focus on customer satisfaction rather than profit maximization. The problem remains at the forefront because there are no easy answers.