Profitability analysis and improving profit margins

The current economic climate is causing profound challenges for business owners across industries. Not only is inflation on the rise, but increased costs associated with food and housing mean that buyers everywhere are feeling the strain. With more shoppers prioritizing necessities, businesses increasingly have to make adjustments to stay in the black. 

A profitability ratio used by analysts and investors, profit margin, helps reveal whether a business is making or losing money. To determine profit margins, companies subtract the total cost of providing a product or service from the sales price paid for the item by customers. Along with material costs, finance teams need to consider factors such as labor, storage, equipment depreciation, shipping, and rent or mortgage payments. The goal is to identify ways of maximizing margins without reducing product quality or customer satisfaction. 

With that said, it's important to gain a greater understanding of your profitability which requires more analysis than a financial statement and a balance sheet. By doing a profitability analysis, companies can identify specific areas in need of attention. We’ve compiled a list things that you should do and those you should avoid as you prepare a profitability analysis.

One: Do (at least) 3

There are 3 key analyses that you can do to help determine profitability. Don’t be tempted to stop at only one or two of them. Each of them provides a different view of your situation.

Gross Profit Margin:

Your gross profit margin is the amount of your sales revenue minus the cost of your goods. In conjunction with your other numbers, your gross profit margin can tell you if your products are profitable enough, if you need to increase sales or if your expenses, like sales costs, are too high.

Net Profit Margin:

A little more complicated than your Gross Profit Margin, the Net Profit Margin is sometimes simply called the profit margin. To get this number, subtract your expenses from your revenues to get your net profit. Then divide that by your revenue. This will give you a 10,000 foot view of your overall profitability.

Segment Profit:

Few businesses have only one product or service. It’s important to understand the profit for each of your lines of business or products. You can calculate this either by taking the revenue for the segments and subtracting the associated costs or can include a portion of overhead costs – like rent, utilities, salaries, etc. – into the calculation.

Two: Now Do Them for The Past

Once you’ve done those calculations for your current numbers, go back and do them for quarters or years past. By comparing your current numbers by your past performance, you’ll know if you’re moving in the right – and more profitable – direction and be able to pinpoint areas that need attention.

Three: Benchmark Industry Profitability Ratios

Your profit margin might look weak to you, but is it? Different industries have different levels of profitability. Real estate, health care, and financial services tend to have high profit margins. Other industries, like autos, and grocery, have margins that are much lower. Benchmark your industry before looking at your profitability so you know what to aim for.

Four: Understand Customer Valuation

Your customers are the source of your revenue – and your profits. But how much are they really worth? Are you spending like crazy to acquire new customers? Are your service customers better at producing profits than your products? Obviously, this data must be taken in context with the rest of the business. A low valuation customer who typically purchases high margin items later on is a good investment. But you need to understand which is which. Does this make those customers the most valuable? It’s best to look closely at the value of each customer. While some may bring you the majority of your profits, they may not be profitable. That 20 percent could be the ones with the biggest discounts or those that purchase the lowest margin services or products.

Five: Don’t be Held Back by Tools

To be effective, profitability analysis should be done regularly. It can be difficult to do, though, when you use a tool that has high overhead to performing calculations, like spreadsheets. A tool built for enabling fast calculations and pulling in a lot of data can make the difference between performing these analyses often enough to help, or infrequently enough that they mean little to decision making.

Six: Free Up Time for Deeper Analysis

This is another area where the right tool can make all the difference. Tools that remove tedious data entry and model management free up time for more in-depth analysis. For instance, in the interest of time, many finance leaders turn to apportioning as a tool for cost allocation. Apportionment doesn’t give the full picture, however. Driver-based cost allocation results in a more accurate analysis but takes more time. When you alleviate manual tasks with the right tools, you have time to invest in deep analysis.

Seven: Don’t Stop at Insights

The results of these analyses can, and will, provide much deeper insights for the organization to understand what your profitability looks like. Your analysis shouldn’t stop there. Instead, the results should drive finance teams to ask better questions and use data to help find the answers.

Three Ways to Increase Profit Margins Today:

And now that we have done a deep dive into profitability analysis, here are three of top tips for increasing profit margins regardless of what the economy has in store.

1. Improve Efficiency

If you want to maximize profit margins, increasing operational efficiency is the first step. Start by dividing all business costs into three categories: those that are essential, those that are simply important, and those that are desirable but not necessary. The most innovative finance leaders involve their teams in this process, encouraging workers to identify opportunities to improve efficiency in each category. The goal is to reduce spend in the important and desirable buckets without sacrificing anything that will significantly impact product quality or customer contentment. 

While reducing costs is always a challenge, businesses can utilize automation to minimize disruption to customers or employees. Sophisticated FP&A software tools like Centage enable finance teams to automate routine tasks such as manual data entry, accelerating workflows and improving forecasting. The end result is that you get the data you need faster for more accurate forecasts all without overburdening staff and increasing budgets. 

 2. Optimize Costs

It’s hard to raise profit margins without either increasing sales or cutting costs. Since many customers are feeling squeezed by the current economic climate, raising prices on existing goods may not be the way to go. After all, shoppers may choose to take their business elsewhere if you charge them more for the same items. Instead, companies should consider adding new products to their line to boost margins. Look for ways to solve customers problems without creating new issues for your manufacturing or supply chain.

Additionally, companies can increase margins by optimizing costs. In some cases, leaders may be able to negotiate lower prices from suppliers by agreeing to longer-term contracts. In other situations, it might make sense to look to another supplier for better rates on materials or services. 

Another way to optimize costs is to look at your customers themselves. As they are the source of your revenue – and your profits  – but how much are they really worth? Are you spending like crazy to acquire new customers? Are your service customers better at producing profits than your products? Obviously, this data must be taken in context with the rest of the business. A low valuation customer who typically later purchases high margin items is a good investment. But you need to understand which is which. Does this make those latter customers the most valuable? It’s best to look closely at the value of each customer. While some may bring you the majority of your profits, they may not be profitable. That 20 percent could be the ones with the biggest discounts or those that purchase the lowest margin services or products.

3. Determine Prices

Ultimately, successful price optimization is crucial to turning a profit. The most savvy business leaders test multiple methods of raising average sales prices without making changes too quickly. After all, driving prices too high too fast can cause a rapid drop in volume. The goal is to model different assumptions and track them over time. 

Moreover, businesses need to strike the right balance between making money and providing value. Customer surveys are a useful tool for gathering information on demographics, psychographics, and buying behavior. Recognizing that spreadsheets are both unwieldy and prone to errors, companies are increasingly using financial planning tools to assess the impact of multiple scenarios. Additionally, businesses should evaluate regional market specifics, historic sales data, and demand fluctuations throughout the months and years. 

Financial visibility and control are essential to helping businesses stay profitable. Ideal for today’s volatile economy, Centage is a financial budgeting, planning and analysis software created by and for modern finance leaders. Offering sophisticated budgeting, superior forecasting, and faster data analysis, Centage enables companies to maximize profit margins without sacrificing product or service quality. Whether you’re looking to collaborate with employees around the world or use automation to allow workers to do their jobs more effectively, this cutting-edge software can help your business succeed.