Profitability Framework

Understanding profitability issues can help executives, consultants and entrepreneurs to diagnose and respond to falling prices,

declining sales volume and rising costs

Businesses sometimes experience reduced profitability.

This is not necessarily a problem if the decline was expected since a business can be sustained from cash flow, and long term growth can be pursued through capital accumulation, which shows up on the balance sheet not on the profit and loss statement.

However, a drop in profits can be concerning if it is unexpected and unexplained. It can limit a business’s ability to achieve organic growth and may mean that its existing business model is no longer viable.

1. Profit

1. Profit

Profit equals revenue minus cost.

By considering the broader economy and comparing a business’s performance numbers with the competition it will be possible to determine whether declining profitability is a company specific or industry wide problem.

Assuming the issue is company specific, it will be possible to discover the source of declining profitability by investigating each branch of the profit equation, revenue and cost, and drilling down to explore the company’s current and historical performance figures.

Declining profitability may result from falling prices, declining units sold, rising costs or a combination of these factors.

2. Revenue

Revenue can come from various sources including advertising and

product sales and is normally thought of as being a function of price per unit and units sold. For example, price per widget multiplied by the number of widgets, or cost per click multiplied by the number of clicks.

Declining revenue can derive from a fall in prices or a reduction in units sold, and can be examined in four steps.

Step 1: Segmentation

What are the major revenue streams? It will typically be a good idea to segment units sold, and this might be done by:

1. Product;

2. Product line;

3. Distribution channel;

4. Region;

5. Customer type (new/old, big/small); or

Step 2: Examination

What percentage of total revenue does each revenue stream represent?

Compare current and historical figures to identify how these percentages have changed over time.

Step 3: Diagnosis

What is the underlying cause of the problem?

Step 4: Response

Develop a strategic response.

2.1 Diagnosis

If faced with declining prices or sales volume, factors to consider include the following.

1. Macro Economy

 PEST Analysis: Are there recent or impending changes to the macro environment? This may include changes to political, economic, socio-cultural or technological factors.

2. Customers

 Market growth: Has market growth slowed forcing competitors to compete for market share?

 Customer needs and preferences: Have customer needs and preferences changed?

 Price Discrimination: Is the fall in prices or sales volume

attributable to a particular customer segment? Can the company distinguish between customers and charge different prices to different customer segments? This could be done by offering quantity discounts or by distinguishing between people in different groups (e.g. students) or in different locations (e.g. you pay more for popcorn at the cinemas).

 Distribution Channels: What channels are used to reach

customers? Have new or preferred channels become available?

Has there been a change in the cost effectiveness of these channels?

3. Competition

 Rivalry: Have competitors lowered their prices? How does the company’s product mix, product quality, and cost structure compare to the competition?

 Substitutes: Has the availability of substitutes increased or the price performance of substitutes improved?

 Barriers to entry: Has it become easier for new competitors to enter the industry? For example, the Internet has enabled new entrants in many established industries including publishing, newspapers, and taxis.

 Buyer bargaining power: Has there been an increase in customer bargaining power? For example, Amazon has used its market dominance to drive down the price of books much to the chagrin of book publishers.

4. Company

 Market Power: Does the company have market power that might allow it to raise prices (monopoly, product differentiation,

proprietary technology, economies of scale, network effects)? For example, De Beers had (and largely still has) a monopoly on the diamond trade which allows it to keep the price of diamonds high.

 Products: What products and product mix does the company offer? How does this compare to the competition? Is there something different about the products that might allow the

company to raise prices? For example, brand recognition, superior quality, appealing design, unique product features, or strong

customer service.

 Value chain analysis: Consider value chain activities such as access to raw materials, operating capacity, inventory handling and

distribution. Are there any bottlenecks or capacity limitations?

2.2 Response Declining prices

You would be forgiven for thinking that the best way to respond to falling prices is simply to raise them. But unfortunately things are often not that simple since a business’s ability to raise prices can often be constrained.

In response to declining prices, there are three pricing strategies to consider:

1. Competitive pricing: How do prices compare with the

competition? Is the pricing appropriate given the product’s relative quality and position within the market? How is the competition likely to respond to the firm’s pricing strategy?

2. Cost based pricing: Cost based pricing is a simple pricing strategy that sets price relative to the company’s costs. The price is set by calculating the company’s per unit cost and adding a margin for profit.

3. Value based pricing: Value based pricing involves assessing the customer and setting the price based on the customer’s willingness to pay.

For further discussion on pricing strategy, see “3.5.1 Four Ps Framework”.

Declining sales volume

Faced with falling sales volume, there are four growth strategies that a company might employ: market penetration, market development, product development, and diversification.

Figure 2: Product/market expansion matrix

For more information on growth strategy, see “3.4.1 Product / Market Expansion Matrix”.

3. Costs

The third driver of declining profitability is rising costs.

3.1 Diagnosis

If rising costs are driving a decline in profitability, then the cost structure of the business will need to be examined in order to locate the source of the cost blow out. This might be done by segmenting costs into value chain activities: inbound logistics, operations, outbound logistics, sales &

marketing, customer service (see “3.2.1 Value Chain Analysis”).

Have there been any significant changes in the company’s cost drivers?

How do costs compare to the competition?

3.2 Response

After determining the source of rising costs, a firm can develop

strategies to manage and reduce costs. For more information on cost management, see “3.6 Cost Management”.

4. Profitability Framework Cheatsheet

If you would like to download a one page profitability framework

cheatsheet that contains all the essentials of the profitability framework on one page, please click here.