The overall objective of any business is to maximize profitability. From the first day on, the activities of the business culminate in an attempt to create sustainable and ample profit. Business leaders rely on a variety of tools and analyses to help identify ways to maximize profit and create new ways of generating profit. One tool they rely on is profitability analysis, which assists them in understanding how profitable the business is.
This FAQ will serve as a guide to help you understand what profitability analysis is, why it is important, and the methods of performing profitability analysis.
What Is Profitability Analysis?
Profitability analysis is part of enterprise resource planning (ERP) and helps business leaders to identify ways to optimize profitability as it relates to various projects, plans, or products. It is the process of systematically analyzing profits derived from the various revenue streams of the business.
Sometimes profitability analysis is incorrectly assumed to exclusively rely on profitability ratios. In fact, profitability analysis relies on both qualitative and quantitative analytics to help leaders get the full picture.
While profitability analysis does answer many quantitative questions, it is unique in that it can also help business leaders identify which sources of information are most factual and reliable. This is especially helpful in helping to select new enterprise resource planning solutions as the need for factual and reliable data is paramount.
ERP systems combine information from a variety of business processes and enable the flow of information between them. Advancements in ERP solutions have created access to more transparent and helpful information than in the past. This transactional information can be used to help perform holistic profitability analysis which often includes a deep look into which customers, vendors, and geographical locations are most profitable.
Why Is Profitability Analysis Important?
Understanding the quality of a business’s earnings is important for many reasons. In order to maximize profits, business leaders first need to understand the drivers behind their profits. This helps to create efficiencies in the processes and activities that generate revenue. Consequently, it forces leaders to continually find ways to reduce overhead and other costs that impact profitability.
The analysis helps to identify ways to enhance product mixes to maximize profits both in the near and short term. This makes it helpful for budgeting purposes as leaders work to create reasonable goals and map how they will achieve them. The ability to identify both short- and long-term product mixes also helps management to determine what modifications, if any, need to be made to the business.
This results in the ability to anticipate sales and provides insights into customer demographics, geographic considerations, and product types that can be used to assess profit potential.
One helpful piece of information created when analyzing various products is which products are the most and least profitable. This information is sometimes taken into consideration when business leaders choose to eliminate certain products.
Finally, profitability analysis examines the various relationships with customers and vendors. This helps to identify which customers are the most and least profitable and which vendors have the biggest impact on profitability. This can be especially helpful in navigating relationships with customers and vendors.
Common Methods Of Performing Profitability Analysis
There are many ways to carry out analysis on profitability. Some industries have considerations that are specific and unique to the businesses that operate within them. While each business ultimately goes about it differently, here are three common methods of profitability analysis.
Profitability ratios are financial metrics that are used to garner information on how well the business can generate revenue relative to its cost, assets, and equity over time. Some of the more common profitability ratios are operating profit margin, return on assets (ROA), and return on equity (ROE).
Customer Profitability Analysis
A great deal of attention is given to the data created as a result of transactions. The data provides unique insight into customers’ behaviors. As a result, transaction analysis can help to identify which customers result in the most profit, and which customers result in the least. It also helps to identify which products and product mixes are most commonly ordered.
The most common approach is to calculate profit margin for each customer. However, profit per customer share is sometimes relied on as well. This helps to show the percentage of profit each customer is responsible for creating.
It is important for leaders to continually assess the various market conditions and relevant customer behavior patterns. This helps to identify trends and business cycles and allows leaders to plan appropriately.
Using DataRails, a Budgeting and Forecasting Solution
DataRails’ FP&A software replaces spreadsheets with real-time data and integrates fragmented workbooks and data sources into one centralized location. This allows users to work in the comfort of Microsoft Excel with the support of a much more sophisticated data management system at their disposal.
Every finance department knows how tedious building a budget and forecast can be. Integrating cash flow forecasts with real-time data and up-to-date budgets is a powerful tool that makes forecasting cash easier, more efficient, and shifts the focus to cash analytics.
Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
DataRails is an enhanced data management tool that can help your team create and monitor cash flow against budgets faster and more accurately than ever before.