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
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.
Qualitative Analytics
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.
Example of Performing Profitability Analytics in a Business
Let’s use an example of a small business performing profitability analysis using two popular profitability ratios: return on assets (ROA) and return on equity (ROE):
Let’s say we have a small business that has $100,000 in total assets and $50,000 in total equity. The business earns $10,000 in net income for the year.
To calculate ROA, we would use the following formula:
ROA = Net Income / Total Assets
ROA = $10,000 / $100,000
ROA = 0.1 or 10%
This means that for every dollar of assets the business has, it is earning 10 cents in net income.
To calculate ROE, we would use the following formula:
ROE = Net Income / Total Equity
ROE = $10,000 / $50,000
ROE = 0.2 or 20%
This means that for every dollar of equity the business has, it is earning 20 cents in net income.
By comparing these ratios to industry benchmarks or previous periods, the business can determine if it is doing well or not and take action based on that.
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