When a company is losing money, the focus is on how to reverse that trend. When your revenue exceeds your expenses, however, an organization may be in less of a hurry to break that information down – which is where profitability analysis comes into play.
The truth is, while you may be turning a profit, you may not be making as much as you could be. When profit is only viewed as a binary – yes, we’re making more than we’re spending or no, we’re not – the real story may be masked by simplicity. For instance, what if you have one product or service that is wildly profitable, and another that is losing money?
Gaining a greater understanding of your profitability requires more analysis than a financial statement and a balance sheet. By doing a profitability analysis, companies can identify areas in need of attention. We’ve compiled 8 things that you should do and those you should avoid as you prepare a profitability analysis.
One: Do (at least) 3
There are 3 key analyses that you can do to help determine profitability. Don’t be tempted to stop at only one or two of them. Each of them provides a different view of your situation.
Gross Profit Margin:
Your gross profit margin is the amount of your sales revenue minus the cost of your goods. In conjunction with your other numbers, your gross profit margin can tell you if your products are profitable enough, if you need to increase sales or if your expenses, like sales costs, are too high.
Net Profit Margin:
A little more complicated than your Gross Profit Margin, the Net Profit Margin is sometimes simply called the profit margin. To get this number, subtract your expenses from your revenues to get your net profit. Then divide that by your revenue. This will give you a 10,000 foot view of your overall profitability.
Few businesses have only one product or service. It’s important to understand the profit for each of your lines of business or products. You can calculate this either by taking the revenue for the segments and subtracting the associated costs or can include a portion of overhead costs – like rent, utilities, salaries, etc. – into the calculation.
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Two: Now Do Them for The Past
Once you’ve done those calculations for your current numbers, go back and do them for quarters or years past. By comparing your current numbers by your past performance, you’ll know if you’re moving in the right – and more profitable – direction and be able to pinpoint areas that need attention.
Three: Benchmark Industry Profitability Ratios
Your profit margin might look weak to you, but is it? Different industries have different levels of profitability. Real estate, health care, and financial services tend to have high profit margins. Other industries, like autos, and grocery, have margins that are much lower. Benchmark your industry before looking at your profitability so you know what to aim for.
Four: Understand Customer Valuation
Your customers are the source of your revenue – and your profits. But how much are they really worth? Are you spending like crazy to acquire new customers? Are your service customers better at producing profits than your products? Obviously, this data must be taken in context with the rest of the business. A low valuation customer who typically later purchases high margin items is a good investment. But you need to understand which is which before you can make smart strategy decisions.
Five: Don’t Assume Your Best Customers are Your Most Valuable
When discussing customers in finance, we frequently reference the 20:80 rule – 20 percent of your customers bring in 80 percent of your revenue. Does that make those customers the most valuable? It’s best to look closely at the value of each customer. While some may bring you the majority of your profits, they may not be profitable. That 20 percent could be the ones with the biggest discounts or those that purchase the lowest margin services or products.
Six: Don’t be Held Back by Tools
To be effective, profitability analysis should be done regularly. It can be difficult to do, though, when you use a tool that has high overhead to performing calculations, like spreadsheets. A tool built for enabling fast calculations and pulling in a lot of data can make the difference between performing these analyses often enough to help, or infrequently enough that they mean little to decision making.
Seven: Free Up Time for Deeper Analysis
This is another area where the right tool can make all the difference. Tools that remove tedious data entry and model management free up time for more in-depth analysis. For instance, in the interest of time, many finance leaders turn to apportioning as a tool for cost allocation. Apportionment doesn’t give the full picture, however. Driver-based cost allocation results in a more accurate analysis but takes more time. When you alleviate manual tasks with the right tools, you have time to invest in deep analysis.
Eight: Don’t Stop at Insights
The results of these analyses can, and will, provide much deeper insights for the organization to understand what your profitability looks like. Your analysis shouldn’t stop there. Instead, the results should drive finance teams to ask better questions and use data to help find the answers.
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