Profit Drivers - Profitability Analysis, Financial Analysis and Reporting | Financial Analysis and Reporting - B Com PDF Download

One of the toughest challenges smaller companies face is learning how to manage their financial performance. Entrepreneurs often think that great financial results just "happen," but that is seldom the case. Companies do get lucky sometimes, but success usually comes to those who are willing to roll up their sleeves and do the hard yards. Companies like GE, Dell and Ebay achieve consistent profitability because they know the critical factors that drive their profitability and work relentlessly on those areas of the business. Following is a list of the key profit drivers for most companies and an explanation of why one driver in particular (price) is far more important than all the others.

Key Profit Drivers

For most businesses, there are four major profit drivers:

1. price,
2. variable costs (i.e. those costs that vary in direct proportion to revenue, typically represented by cost of sales),
3. fixed costs (or overhead), and
4. sales volume. In other words, these are the underlying issues that directly determine your company's financial performance.

If you want to increase profitability, then you have to work on these areas.

The Importance of Price

Which leads to an interesting question: do all of these drivers have the same impact on profit? Without getting into too much detail, the simple answer is: no. In fact, price will always have an impact that is two or three times greater than any of the other drivers. The reason for this is quite straightforward: an increase in price has the greatest impact because every additional dollar goes straight to profit. By comparison, an increase in sales volume will be accompanied by an increase in variable costs, so the gain will be smaller. A decrease in variable costs will increase the margin but will not increase overall revenue. Finally, a reduction in fixed costs (i.e. overhead) has no impact on revenue and therefore will always have the smallest impact of all.

Two Classic Mistakes

The strategic implications of this analysis are very important. Many business people are preoccupied with getting more revenue, often from new customers. However, they often pay little regard to the customers they already have and usually adopt the view that price is something over which they have very little control because of competitive pressure (classic mistake #1). They also believe that reducing costs is the most effective way to building a profitable business (classic mistake #2).

This is absolutely the wrong way to run a business. Even though it makes intuitive sense that cutting costs leads to improved profitability, there is a big qualifier to this. If a cost is necessary for you to do business (for example, customer service costs), then reducing it may reduce your capacity to do business. Furthermore, the costs that can be reduced most easily are usually those of a "discretionary" nature, and these tend to be the ones geared toward building the future of your business (marketing, team training, R&D, etc.).

As far as pricing is concerned, you might be thinking to yourself: "That's all well and good in theory but if I increase my prices, how much business would I lose?" That's a good question but a far better one is, "How many customers could I lose and still make the same amount of profit?" The answer might surprise you. For example, it is entirely possible that a company could raise its prices by 10%, lose 25% of its customers, and actually make more profit. In other words, the company could lose a quarter of its customers and still be better off. Furthermore, if that were to happen, which customers do you think the company might lose? We suspect that it might be those customers who are most price-sensitive and cause the greatest amount of stress for you your team.

Conclusion

The bottom line is this: far and away the most effective strategy for maximizing your company's profit is to aggressively price your products or services, elect to deal only with those customers who see the value that you deliver to them, and not allow price-sensitive customers or competitors dictate your company's pricing strategy across the board. At the end of the day, profitability is the only measure of success. Revenue does not pay the bills or give you the resources you need to grow- that comes from profit.