What is Profitability Analysis?
In today’s competitive environment, there is a need for most companies to analyze their profitability whether it be by Product, Customer, or Location in order to gain operational efficiencies.
Profitability Analysis involves the allocation of expenses and analyzing profitability across several different dimensions or vantage points within the company. While a company’s profitability in total is an easy number to calculate, profitability at detailed levels is tough because of the differing granularities in accounting activities. For example, in a lot of companies, sales revenue may be booked by product and customer. Something like IT costs may get booked by department, but not by customer or by product.
If we look at an Income Statement for a company like this, the data populates in a pattern that looks something like:
In order to analyze whether a Product Group or Customer Segment is truly profitable, the costs the total company incurs need to be allocated to the products and customers. As an example, if the group that supports a given product takes up 20% of the square footage of a building, a company may choose to allocate 20% of the building’s rent expense to that product.
Profitability Analysis is the exercise of getting to “a fully loaded” Income Statement. An Income Statement that has costs allocated to all dimensions:
The Importance of Profitability Analysis
As you can guess, a lack of visibility into true profitability can have a host of negative effects on performance. Below is a survey of FP&A professionals regarding the implications of poor visibility:
Aside from the impact felt on operations, the latter chart illustrates the importance of those numbers in the target setting process. Profitability is THE #2 FACTOR in people’s forward-looking decision making. You could also argue that it has a drastic impact on #1 (strategy).
What can good Profitability insight can do for you?
Imagine we had a company that sold widgets. And we created a chart by ordering our customers from most to least profitable and mapped total ending profit. This type of chart, commonly known as a “whale chart”, might look something like this:
In the whale chart, we see 55% of customers are very profitable. 15% are more or less at breakeven from a profitability perspective. And 30% of customers actually cost the company money to service. Imagine if you could identify those 30% of customers. The potential revenue impact is nearly $1B in this example. Even just the last 10% of customers were a $500M negative impact. While the numbers and the company are fictitious, the shape of a typical chart like this is not.
What profitability analysis can do for your business is helpful in identifying the demographics that make up these segments. By product, by customer segment, by location, or by any other dimension that’s important to your business. Armed with a good system to analyze this information, FP&A teams can help analyze trends impacting profitability and recommend actionable changes to company behaviors to leadership. This may involve more appropriate pricing of goods and services. Or exiting ventures to curb non-profitable areas or maximizing on previously unseen trends or competitive advantages to increase focus on the company’s most profitable areas.
Wondering how your finance team can adapt to ever-changing demands? Are there more efficient ways to budget? What exactly are dynamic planning strategies?
We will walk through how organizations can most effectively adapt to change through preparation, management and reinforcement, plus the critical transformational role FP&A teams have within an organization to encourage faster, smarter decisions!