Published August 2003

Facing profit decline?
Focus on strengths

The profit motive is a powerful one. The lure of profit attracts people to start businesses, create new products and improve old ones. Profits in a business also attract competitors, a process that leads to the kind of market efficiency and overall performance our economy has enjoyed for so long. But the decline or disappearance of profits is a powerful motivator, too. A declining profit margin may be just a wakeup call.

But a shrinking bottom line is what radio’s “Car Guys,” Tom and Ray Magliozzi, call a “dope slap.”

A lot of companies across America, and especially in Washington, have recently been facing shrinking profits. These companies can be divided into two groups: those who are hoping that the situation will get better, and those who are doing something about it. And, for several reasons, the “doing something” group is more likely to survive.

That is not to say that doing something will be easy. In a shrinking profit situation, hard decisions have to be made, and these can have painful consequences. And since they are tough choices, it is worthwhile for us to consider exactly what kind of decisions a company with shrinking profits should be looking at, and what kind of guideline, or “golden rule,” management should use.

The fundamental principle of how to respond to shrinking profits is simple — but not easy. The rule is this: do more of what you do well, and less (or none) of what you do poorly. This often boils down to dropping product lines or services, even profitable ones, so that you can concentrate on your business strengths.

The experience of PepsiCo provides an interesting example of this kind of decision — and it also shows that shrinking profits can turn up as a problem even in a booming economy.

In 1997, PepsiCo decided to sell off its KFC (Kentucky Fried Chicken), Pizza Hut and Taco Bell restaurants to Tricom Global Restaurants. Since the restaurants were profitable, and since they seemed like such a perfect fit — the parent company makes soft drinks and snacks (its Frito-Lay division) — many people were puzzled by the decision.

There were several good reasons why the sale made sense, though. The underlying situation was that the restaurants, while still earning money, had been experiencing declining profitability, and when PepsiCo took a look at the causes of the decline, there were several reasons why it seemed to make more sense to sell them off.

The first reason was that the marriage of the soft-drink producer and the restaurants wasn’t as perfect as it first seemed. The restaurant business is a service business, requiring direct, face-to-face contact with the consumer, and this was not something that PepsiCo, overall, was good at. Its expertise was in mass marketing and supermarket sales.

The second reason was that management’s initial response to the declining profitability was to try to squeeze more profits from the existing restaurants by cutting off the flow of cash for maintenance and improvements. The result was a backlog of capital expenditures that were necessary to continue, let alone improve, profitability.

The third reason was that PepsiCo was locked in a life-or-death struggle with Coca-Cola and was very concerned about losing market share. The restaurant business, while still profitable, was clearly going to be a cash drain while it had little potential to effect a significant increase in soft-drink sales. So, PepsiCo decided to sell the restaurants, take the money and put it into its main areas of strength — supermarket sales of its soft drinks and snacks.

Was it the right decision? Probably. It put its money where its strengths were and made itself more competitive in its duel with Coke, which was a battle it could not afford to lose.

Declining profits present that kind of decision to managers no matter how big or how small our businesses might be. When the bottom line is under pressure, our natural instinct is to hold on to everything that is even barely profitable and to put resources into new products or services that we think show some potential for profit. Most businesses, though, are more likely to survive an economic downturn if they concentrate their resources on what works — what they are best at and make money at — and dump everything else.

It is a painful process. People may have to be let go, and that hurts everyone. And to most entrepreneurs and managers it seems like “giving up” when programs, products or services into which you have poured your heart and soul have to be abandoned.

But managers should consider this a survival instinct: When things get tough, the businesses that survive will be the ones that focus on what they do best.

James McCusker, a Bothell economist, educator and small-business consultant, writes “Your Business” in The Herald each Sunday. He can be reached by sending e-mail to otisrep@aol.com.

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