I was recently analyzing a friend’s business and asked him to list three pain points in his operations. One of them will be the topic of today, profitability.
His dilemma with profits was that he felt he had no control over them. He acknowledged that he had relative low variable and fixed costs, which gave him a lot of margin to raise and decrease prices (a luxury not many business segments can afford) without incurring noticeable losses and not knowing what his real profit was. This of course could be fixed with at least three points:
*Determining the fixed and variable costs associated with the product or service
*Having a pricing strategy
Fixed and variable costs
Put it simply the difference between fixed and variable costs are that variable costs are dependent on the number of products made or services provided while fixed costs remain the same no matter the output volume. Variable costs are basically any cost that will increase the more products are made or services given. Examples of variable costs: supplies, sales commissions, raw materials. Examples of fixed costs: rent, utilities, personnel.
Once the variable costs are identified, to know what’s the extra cost for each new unit made or service provided simply divide the total variable costs by the number of units. Having this number comes in handy for forecasting, pricing, and net income formulas.
Unit Variable Cost = Total Variable Costs / Number of Units
If the unit variable cost is obtained the company can go ahead and use it to carry out various sensibility analyses, exploring the effects of producing more and what range balances out the benefits vs costs.
Put it simply, a company is profitable when the revenue is higher than its expenses. The company can carry out various degrees of profitability analysis depending on the insight it’s going after.
It can start by looking at the gross profit, which is:
Gross Profit = Revenue – Cost of Goods Sold
This allows to see the profitability of a product or service taking only into account the direct costs. The formula to obtain the ratio of the gross profit against sales is:
Gross Profit Margin = Gross Profit / Revenue
Why is this important? It illustrates how efficient the company is at covering costs such as labor and raw materials. A low ratio may indicate poor pricing (ex. company sells a lot but because the price is too low the revenue is barely able to cover the direct costs) or inefficiency (which translates to higher costs that could be reduced with efficiency-focused implementations).
If the company wants a deeper analysis, the next step would be the operating profit to see how well the business is handling the rest of the expenses. First it would obtain the operating profit:
Operating Profit = Revenue – (Cost of Goods Sold + Operating Expenses)
This means it is not including neither tax nor interest expenses. It is quite common to use this to measure if the company is making a profit efficiently or not as financing options and taxes can vary. Once the company has the operating profit it can calculate the operating profit margin:
Operating Profit Margin = Operating Income / Total Revenue
The higher the margin the less risky the company is, for it would illustrate efficiency in its operations, good pricing, and a good level of sales.
If the rest of the expenses are a possible concern when it comes to determining profitability, then the next level is calculating the net profit by subtracting the rest of the expenses (taxes, amortization, depreciation, interests) from the operating profit. The corresponding ratio would be net profit margin:
Net Profit Margin = Net Profit / Total Revenue
This ratio allows stakeholders to see how much net profit the company makes for every dollar of revenue obtained.
Coming up with a pricing strategy for new products or service
With a new product or service there may be little or no historical information (brand new) to come up with the pricing that provides a good margin, market share, and/or strong sales. Here the pricing strategy would all be based on research.
The initial part would fall more under marketing research since they would have to do surveys, studies, focus groups, etc. to find a selling price that agrees with the company’s objective and what the market is able to tolerate. Once they have that information and they are able to forecast sales based on the research and benchmarking against products or services in the same range, finance can step in.
Using the sales forecast the finance team would be able to use the estimated volumes to see how many units or services would need to be sold to reach the break-even point (where revenue equals variable + fixed costs). Any sales higher than that would mean profits. All of this allows to determine the minimum sales price, which is important since the company may need to issue discounts and promotions to attract new customers and start gaining market share. Setting a limit is useful so that the company can be conscious when it is intentionally suffering losses as part of its strategy.
Coming up with a pricing strategy for current products or service
Marketing research also plays a big role in defining a pricing strategy for products or services the company is presently providing since benchmarking against existing products or services from the competition is still needed for positioning and market share reference. While sales forecast can be complemented by surveys and research with potential customers, finance can go ahead and make those sales forecast based on financial data from the past quarters and years. With this data they can determine if there are any tendencies, patterns or seasonality.
Once the forecast for the sales volume is made, the same process as mentioned before can be carried out. The company determines the break-even point and the desired profit. Noteworthy to mention is that any expected increases in fixed or variables costs for the corresponding period being estimated should be noted down. Once the pricing and expenses are set for the period, the company can calculate the expected profits.