Profitability is an essential ingredient to the long term viability of a business; however, there is more than one way to look at profitability. We often ask business owners not just about the profit of their business, but the profit within the business.
Profitability is often the universal scorecard for the periodic success of any business. It is the answer to “How much money did we make this month/year?” However, what is often overlooked is the components of that profitability. A deeper understanding can not only lead to improved overall results, but also allow a business owner to have more confidence in decision making and enhance the quality of budgets and projections.
There are three primary categories of profitability within a business:
- Profitability by Employee (most common in service-based businesses)
- Profitability by Product or Service
- Profitability by Customer
Of course, the components are different depending on the type of business and there can be analyses of profitability by business segment as well.
Below we will walk through each in more detail and also provide a few examples.
Determining Profitability by Employee
Let’s use the example of a service business, perhaps a marketing agency that generates revenue by billing hourly work performed by its staff. It would be of value to the business owner to know the profitability of its employees.
If reviewing monthly, we would calculate the revenue generated from billings related to that employee, and then apply that against the costs related to the employee. That cost would include salary, but also bonuses, workers compensation, insurance and payroll taxes, as those are all direct costs related to the employee. Using that information, a matrix can be created to show the profitability of each employee within the company.
So let’s say two employees that perform largely the same function are generating much different profitability on a monthly basis. What could cause that? Well, there could be multiple answers, but below are the two most common:
- Employee utilization. Utilization refers to how much time that employee is billing the clients relative to the total amount of hours in a month. If one employee is billable 60% of the time, and another is billable 85% of the time, profitability could vary significantly between the two employees. Analyzing utilization rates by employee will help a business owner determine the optimal utilization rate for each staff position.
- Mismatch of bill rate to pay. The variation in profitability may be because the company is paying an employee too much relative to the bill rate they are charging to the customer.
Determining Profitability by Product or Service
Many companies produce or distribute more than one type of product or service. For example, a manufacturing company may produce three different products lines. In those situations, it is essential to understand the profitability of each individual product line—not just overall company revenue.
To do this, we take the price charged to the customer for each product and deduct the costs attributed to creating that product. Those costs should include raw materials, personnel, packaging, etc. However, it is not always possible to determine unique costs, such as freight, labor, and the cost of using machinery. In those cases, allocations have to be used. For example, if Widget A takes 6 hours to be manufactured and Widget B takes 2 hours to be manufactured, and employees work 8 hour shifts, we could apply 75% of that employee’s labor cost to Widget A and 25% to Widget B.
Profitability by product or service can be particularly eye opening for a business. Let’s assume a business had three product lines and was selling what it thought was high quantities of each. That business could even be profitable as a whole. But consider if one of those three products was actually losing money. The business could potentially forfeit a significant portion of sales and still generate more to the bottom line. Now, there are times when one product is sold as a loss leader to aid in the sales of other products. That can be a great strategy, but the business owner should know profitability by product or service to best determine the right sales mix for the business.
Determining Profitability by Customer
For any business that sells products and services, an evaluation of profitability by customer can be performed. We would perform an analysis of the revenue generated for each customer and then deduct from that all costs directly attributed to providing products and services to that customer. That could include labor, materials, shipping, travel, and anything else that was directly tied to that particular sale.
The results of this analysis are often surprising as many businesses actually lose money on some customers. This goes to the misguided notion that any sale is a good sale. By ceasing to work with certain customers, companies can actually improve overall profitability. At a minimum, it invites a discussion around pricing for products and services provided and/or a deeper look at costs required to produce those products and services. For example, if a business is running very lean from a cost standpoint, it simply may have to charge more for its products to some, if not all, of its customers.
There is often an opportunity in costs as well. Especially in businesses with material competition, the ability to change prices can be limited, which makes cost control even more important. Is the labor force working at capacity? Can materials be purchased cheaper from suppliers? How significant are shipping costs to the business? Those are all questions at the heart of cost control in an effort to improve margins in the business.
Putting this kind of information in the hands of the business owner, operations team and the sales force can be instrumental in creating a better pricing strategy, sales mix and cost management that can lead to an improved bottom line. These tools could be a major catalyst for long-term success, and should be in the tool-box of every business owner. Contact us today to learn more or to schedule a free consultation.