No number exists in a vacuum. Looking at revenue without also considering expenses won’t tell you much. You don’t see the profit level subtracting the “middle line” from the “to line” to calculate the all-important “bottom line.” Counting customers without also tracking attrition is a wasted exercise. And that need to consider context and complexity certainly extends to profitability. While the C-suite might focus on net profit margin, finance pros know that profitability analysis should be more than a barometer to the company’s performance: It can actually drive decision-making and move the needle on future profits.
Who are your most profitable customers to retain and grow? Who are least profitable? Who might be your most valuable customers going forward? Customers are the source of financial value creation for shareholders and owners. Don’t stop at reporting at the product or service gross profit margins line. Go below that line to trace expenses consumed by customers for distribution channels, selling, marketing, and customer service. Produce a P&L statement for each customer. Sales volume is not a proxy for the profitability level of a customer because demanding customers, possibly granted deep price discounts, erode profits compared to less demanding customers with relatively low sales volume.
How efficient is your business at generating profits? Is performance getting better or worse? How do you know? Profitability analysis. Conducting a profitability analysis means crunching the numbers to calculate specific profitability ratios—like gross margin, operating margin, free cash flow margin, etc.—during a specific accounting period and on a particular part of the business. Then, put those metrics to use in an analysis of what’s working, what’s worthwhile, and what should be changed for the future.
As the competitive landscape shifts, customer demands change, or your company seizes new opportunities, profitability analysis can help you better parse specific results and deliver those insights to business leaders and managers to guide strategic planning. Rather than relying on a bird’s-eye view of the financials or (even worse) gut intuition, the C-suite and managers can have granular, fact-based answers around how profitable each customer group, specific customer, market, product, and/or service line is.
Ready to strengthen your team’s profitability analysis? Consider these five tips:
FP&A message boards are rife with finance pros grumbling about how time-intensive the effort for profitability analysis can be. And who could blame them? If you’re stuck trying to perform data-intensive calculations with clunky Excel-based spreadsheets and systems, it’s hard to elevate your analysis game.
First, you need a data foundation that supports more sophisticated operations. That means swapping manual data entry and hours spent ticking and tying the numbers with an easy, powerful cloud-based solution that’s going to create a single source of truth. When assumptions or actuals need changing, a few keystrokes can update that data across the entire financial plan. And when you’re building complex conditions to scrutinize profitability, you don’t have to waste time or worry that the underlying numbers might contain a typo or duplicate data entry that will throw everything else off. So-called dirty data can be cleansed with IT tools.
A recent PwC survey found that, thanks to technology, top-performing finance professionals are able to spend 20% more time on analysis rather than on data gathering and validating. In other words, if you’re not already using a modern finance tool to track the metrics and drivers that matter to improving your profit margins, getting those systems in place is step one.
For many time-strapped finance pros, profitability analysis leans heavily on apportionment—an alternative term for cost allocations. In fact, in a KPMG survey of finance leaders, 66% of respondents said apportioning, rather than drivers, was used as the basis for where they allocated shared and indirect expenses to calculate costs in profitability analysis.
That’s a misstep. When you use apportionment, you’re basically spreading like butter across bread the aggregated indirect expenses across a segment of revenue—without accurately reflecting the true amount of the resource expenses that the customer group or subsidiary or product category actually consumed. The cost calculations are flawed and misleading despite reconciling the total expenses to total costs. Let’s say, for instance, you allocate one manager’s compensation across three customer segments, but one of those segments actually takes up 80 percent of the manager’s time. That crude apportionment means you’ve bolstered the profitability perception of the more demanding customer segment and sunk the perceived profitability of the less demanding ones. You have a violated a universal principle of cost accounting—the cause and effect principle. When you consider that profitability analysis, at its best, should be providing insights, creating useful questions, and guiding future conversations around which customer segments, even which customers, to nurture or nix, that’s especially troubling.
Replacing apportionment with a driver-based approach creates a more accurate and informed picture of the true profitability. That’s because it ties labor and equipment work activities performed directly with the cost consumed or income generated from undertaking those activities. You can parse your profitability as finely as needed, confident that the accuracy is intact. It is better to be approximately correct than precisely inaccurate using crude apportionment for costing.
While the sales team is celebrating another customer or client that they closed a deal with, or the product team is busy high-fiving each other regarding another 5,000 units sold, the finance team is in the unique position to understand with reasonable accuracy how profitable those wins actually are. And sometimes, profitability analysis shows that a new customer segment is actually costing the company money, or a new product launch is crimping the margins.
There are reasons to pursue projects that aren’t immediately (or even ever) highly profitable, of course. They involve investment decisions with longer-term payback. Maybe the product launch needs time to reach its tipping point of profitability, or maybe the money-losing customer segment is a first foray into a lucrative market. But having the analysis in place to show what those profits look like now—and being able to model them into the future—can lead to a critical conversation with the C-suite.
It may be that the analysis sparks a hard conversation about killing off a pet project or scaling back an initiative that’s been going gangbusters. For instance, an Accenture case study looked at a European electronics company that turned its attention to profitability analysis with surprising results: Though many of its products were top-sellers, the team found that two categories outperformed all others from a profit standpoint, and three categories actually dragged down rather than produced net profit. Rather than kill those lagging categories, the company changed its pricing structure and revised its upsell and cross-sell strategies. It also doubled down on those high-profit products in marketing materials, to make sure they were promoted to all customers.
That type of actionable insight doesn’t come from studying the income or expenses of each product category, or even trying to apportion fixed and operating expenses across rough margins. It comes from profitability analysis and a willingness to dig deep into the analysis to see how strategic changes can drive cumulative profit.
You don’t need a finance degree to know that bigger profits are better. But what level a healthy profit margin looks like will depend on a variety of internal and external factors—and benchmarking current profits is a proactive way to make sure performance is constantly improving.
You’ll want to do this both internally—pitting one segment against another or comparing current profit margins to past quarters or periods—and externally. In January 2018, the average net margin across industries was 7.9%, for instance, according to NYU’s Stern School of Business.
But before you break out the Champagne to celebrate your 10% margins, consider that nonfinance and non-insurance companies actually hover closer to 26.46%. For the most targeted approach, benchmark externally against both the industry and, if possible, geographic competitors. Compare apples to apples, not to oranges.
Finding the appropriate benchmarks doesn’t have to require days of digging, either. Workday Adaptive Planning, for instance, combines benchmarking from OPEXEngine, along with best-practice models and KPIs, with its Workday Adaptive Planning integrated planning and analytics platform. That allows our customers to leverage data from 400 benchmarks, both generally accepted accounting principles and not.
If the finance team thinks of profitability analysis about as often as they approach the annual plan, it’s time to increase that cadence with more frequent analysis and current data. Every roll-out, product launch, or market expansion should have a timeline for assessing its profitability, as should ongoing operations.
For many companies, increasing how often profitability analysis occurs is a capacity challenge. For others, it’s a capabilities issue, as the FP&A team has been so far tasked with tactical chores rather than encouraged to flex and strengthen its analysis and strategic chops. Setting a schedule for more frequent profitability analysis may need to start with analyzing your current team—both its capacity and capabilities—and making adjustments as needed.
This article was written by Gary Cokins, an internationally recognized expert, speaker, and author in enterprise and corporate performance management (EPM/CPM) systems.