Profitability
Profitability analysis (also sometimes referred to as financial
analytics) is a relatively new cross-enterprise discipline that unlocks
profit potential to drive performance. Once a management and
accounting-driven reporting exercise, it is now being used to help all
parts of a company gain the insight necessary to deploy limited
resources in pursuit of the most profitable opportunities. Company
departments and divisions, such as sales, marketing, operations and
engineering, can use profitability analysis to answer simple profitfocused questions in the context of Profitability
Profitability analysis primarily involves developing profitability
models that depict business problems. Such a paradigm requires
calculating various analysis scenarios that are based on who is
ultimately using the analytical insights.
Tools to profitability analysis so that they can effectively
• Assess the right profitability measures that optimize business
performance.
• Move from merely a costing-oriented profitability reporting
exercise to a forward-looking profitability modeling paradigm.
• Undertake profitability analysis for different dimensions of
profitability (for example, customer, channel, product and so on).
• Use statistical and advanced analytical techniques to predict
profitability outcomes better and thereby work towards optimizing
resource inputs.
• Tie profitability analysis to all other enterprise performance
management processes such as planning, consolidation and control,
strategy management
Profitability analysis framework
Volume
Revenues
Price
Profitability
Fixed
Costs
Variable
Technique for Profitability Analysis
• Cost Volume Profit Analysis
• Target Profit Analysis
• Du-pont Analysis
Cost Volume Profit Analysis
• Voltar company manufactures and sells a telephone
answering machine. The company’s contribution format
income statement for the most recent year is given below:
Particulars
Total
Per Unit
Percent of sales
Sales (20000)
1200000
$60
100%
Less Variable Exp.
900000
45
?
Contribution
Margin
Less Fixed Exp.
300000
$15
?
Net Operating
Income
240000
$60000
• Management is anxious to improve the company’s profit
performance and has asked for an analysis of a items.
Cost Volume Profit Analysis
• Required:
• 1. Compute the company’s CM ratio and v.exp.
Ratio
• 2. Compute the company’s BEP in both units
and sales dollars
Cost Volume Profit Analysis
1. CMR= CM/SP=$15/$60=25%
• VER=VE/SP=$45/$60=75%
2. Sales= V.Exp.+ F.Exp + Profit
$60Q=$45Q+$240000+$0
$15Q=$240000
Q=16000 units or at $60 per unit, $960000
Target Profit Analysis
• Refer to the data of Voltar Company. Assume that nest year management
wants the company to earn a minimum profit of $90,000. how many units
will have to be sold to meet this target profit figure?
• Equation Method:
Sales= V.Exp.+ F.Exp + Profit
$60Q=$45Q+$240000+$90000
$15Q=$330000
Q=22000 units or at $60 per unit, $960000
• Contribution Margin Method:
=
=22,000 units
DuPont System of Analysis
• Objective:
Find out why a company’s profitability, as measured by ROA and
ROE, is higher or lower than the industry average ROA or ROE
or last year’s company ROA or ROE.
– Example: Kohls – company wanted to grow fast, and was
able to grow ever faster than its planned growth rate
because its profitability as measured by ROE was higher
than expected
• DuPont formula:
ROA = Net Profit Margin x Total Asset Turnover
• Pricing and expense control captured by Net Profit Margin
• Efficiency of asset use captured by Total Asset Turnover
• Company’s over- or underperformance on ROA is due to one or both
of these causes, or “drivers”
DuPont System of Analysis
• Modified DuPont formula:
ROE = Net Profit Margin x Total Asset Turnover x
Leverage Multiplier
Financial
– Financial Leverage Multiplier, or “Equity Multiplier” as some call it, is really a debt
ratio
– More assets financed with debt mean less assets financed with equity, so higher
this number is, the greater the use of financial leverage
– Company can “lever up” ROE by using more debt
– Company’s over- or underperformance on ROE is due to one of three causes, or
“drivers”
– NPM
– TAT
– FLM
• Compare company to itself over time and to industry for most recent year when
doing your DuPont analysis of ROE
DuPont System of Analysis
• Example:
– Kohls has NPM of 7%, TAT of 2, FLM of 1.5
– Department stores industry has NPM of 8%, TAT of 1.5, and FLM of
1.25
• Format to show your DuPont analysis:
Company/Industry
ROE
NPM
TAT
FLM
Kohls
21.0%
7%
2
1.5
Dept. store industry
15.0%
8%
1.5
1.25
•
Conclusion: Kohls has a much better ROE than its industry because (1) its use of
assets is more efficient (it generates more sales per dollar of asset investment) and
(2) because it uses more debt financing. Kohls pricing or expense control are
inferior to the industry, however, and the use of debt constitutes a greater risk for
Kohls because it may not be able to handle the interest payments and principal
repayment.
Productivity and Profitability Relationship
Profitability refers to profit earning capacity of an enterprise. It is
one of the best measurements of evaluating of overall
performance of an enterprise.
But measurement of productivity alone cannot identify the causes
of productivity changes. Profitability may be changed due to
productivity or price cost movement.
Therefore it is necessary to segregate profitability into productivity
and price recovery. Considering the relationships among 3ps
(Productivity, Profitability and Price recovery) profitability is
defined as the product of productivity and price recovery.
Productivity and Profitability Relationship
The following demonstrates this relationship:
• Output Value
= Output Quantity x Unit Price
Profitability
= Productivity
x Price Recovery
Input Value
= Quantity Used x Unit Cost
• Where:
• Profitability =
• Productivity =
• Price Recovery =
Productivity and Profitability Relationship
IF
THEN
Profitability Productivity What will happen
Case
1
HIGH
HIGH
2
HIGH
LOW
3
LOW
HIGH
4
LOW
LOW
Financial condition will be
sound and stable
High profitability may not be
sustained on a long-term
basis .In the long run low
productivity will eat up
profits.
The company may soon be
operating at a loss and may
be on the bring of a shut
down.
Shut down / bankruptcy.
What should be done
Maintain or increase
productivity further
Improve productivity
Improve profitability;
strengthen market
strategy, market research,
market promotion,
advertising and pricing
policy.
Improve productivity and
strengthen market.