Question

Some managers focus on the bottom line, meaning net income. This week, please discuss some of the potential problems associated with such a myopic view. Give an historical example of a business or manager that suffered from excessively focusing on profits for either the company or themselves.

Answer 1

Net income is an important consideration while evaluating the health of the company. A healthier net income reflects:

• Higher profit margin
• Higher ROE
• Higher ROA

However, excessive focus on net income is not justifiable because of following reasons:

• Net income is on accrual basis and is not a reflection of the cash flow. A higher net income may still leave the company starved of cash if  the proportion of credit sales is very high and collection efficiency is low
• Net income doesn't necessarily translate into free cash flow of the firm which usually is the driver of the value of the business.
• Excessive focus on net income may lead to manipulation of accounts and may lure manager to recognize revenue even before they are due for recognition as per generally acceptable accounting principles.
• Net income is a purely monetary and mathematical number. Excessive focus on the same prevents the managers from thinking about management, work experience, culture, self development, growth. It leads to ignorance of several qualitative factors in the organization.
• Excessive focus on net income may put excessive pressure on the employees and teams to perform.

An example:

This has been narrated to be by one of my friends.

The Business Head of the Soaps division in his company was very focussed on profits i.e. net income. He was so engrossed with the net income figure that:

• He allowed various credit payment schemes on the products. Customers were allowed to buy the unit on credit period of first 15 days and subsequently on credit period of 30 days.
• In order to boost the sales, the business head allowed sales to many customers whose credit ratings were not sound
• He hired excessively in sales team and ignored the recruitment requirement of other teams.
• He used to ignore departments like HR, Accounts, Administration, IT because he felt that these departments are useless as they don't contribute to sales and hence to bottomline.

Eventually the company suffered badly on account of excessive feature of the business head on sales:

• There was an excess of credit sales. Quality of such credit sales deteriorated. The firm has to deploy many collection agents to collect money. Overall the working capital of the firm was sent for a toss.
• Sales team reviews increased. The sales team employees felt grumpy and frustrated. This led to resignations.
• Sales team got crowded. When sales decreased to normal, some of the team members had to be fired or redeployed.
• Other departments in the organization felt neglected. They escalated the issue to CEO.

Hope this helps you.