The profitability framework can help executives, consultants and entrepreneurs to diagnose and respond to falling prices, declining sales volume, or rising costs
This is not necessarily a problem if the decline was expected because a business is sustained from cashflow, not profit, and long term growth can be pursued through capital appreciation, which shows up on the balance sheet and 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 sustainable.
In order to remedy the situation, the executive team will need to find out what is happening and why, and will sometimes engage management consultants to help them understand and respond to the problem more quickly and effectively.
Examples are falling sales, rising costs or both. The best way to task the problem will be two-fold: performing a structured (issue tree) and quantitative analysis of the data to isolate the problem and then finding a promising solution for the problem.
The five steps to solve a profitability problem
1. Clarify the problem
Take notes! Start with restating the problem: “Just so we are on the same page, our main objective is to determine the reasons behind the decline in profitability for a chewing gum manufacturer and provide recommendations to improve the profitability of the business, is that correct?”
2. Prepare your structure
As mentioned in the introduction, the terms “declining profitability, falling sales or rising costs” hint at a profitability problem. You now have to isolate the problem and quantify it. A good start to analyse a profit problem is by using the profitability equation:
Profit = Revenue – costs
When profits go down, you either have a decline in revenue, raising costs or both. The best way to find the root cause is to sketch the problem as an issue tree. Start with the more promising part, for instance revenues – because the market is highly competitive.
You can further break down the profit tree like below:
Now you can start with one of the branches. Let’s take the revenue side.
Try to start with the branch of the tree that also has the biggest impact on the case solution (see pareto principle for more details). Share your hypothesis with the interviewer and watch out for hints if you are on the right track.
3. Analyze the revenue side
Whenever you get information that something has changed: quantify it! Ask by how much and in what time period. And very importantly: SEGMENT the revenue streams! You can ask the interviewer whether you can segment the revenues into its component parts. If the interviewer prompts you to do the segmentation, you can think about different customer segments (small business / large business etc., age group, sex etc…), product lines or regions (South America, Asia etc). This segmentation will help you isolate the root of the problem. You’ll be able to develop better and more targeted analyses.
For example, when helping a manufacturer improve his profitability, you may ask: “What are the revenue sources?”. The client tells you that all revenue comes from two products: Product A and Product B. At this point, you might want to know the development of sales over the past couple of years. “How have sales figures developed over the years for both products?”
It could becomes clear that revenue is not the problem because it Product B has grown steadily in recent years. Therefore, it must be costs that rose significantly, leading to a drop in profitability.
If you’ve found the biggest driver of the problem, you often times have to switch to a more qualitative framework like the 4 Cs to find the underlying root cause! Example: when you have less revenue, but the price is the same and units sold dropped you have to find out why. Is there a new competitor on the market? Do you have quality problems, or did you just stop a marketing initiative that you ran for years prior to this drop?
4. Analyse the cost side
Now explore the cost side. You know that costs can be broken down into direct and indirect costs. You can then inquire about the break down of costs: “Please tell me about the direct/indirect cost split for the products.” The interviewer hands you the following graph:
As we know that there are two different product lines, it is advisable to calculate their margins to check if there is a more profitable product line. You calculate the margin for both products based on the following formula:
“I’d like to calculate the margins for both products; do you have information on the different prices and costs for each of them?” The interviewer hands you the following graph:
Based on this, you calculate the margins:
5. Provide a recomendation
“Analyses show that the product whose sales have increased Product B is also the one with lower margins due to the added flavor. Therefore, total profit margins have decreased while sales have increased.”
After you have determined the root cause, you must develop a good logical solution (e.g., developing a competitive response, starting a marketing initiative etc.)
It is important to stay structured even if you think you have reached a final stage. Therefore, categorise your approaches for instance by short-term/easy to implement solutions and long-term ones.
Short term
- Negotiate with current suppliers.
- Look for other suppliers (form partnerships or buy greater amounts with batch discounts).
Long term
- Vertical integration.
- Release new products with better margins
- The client could also increase the price of the flavored gum, risking decreasing sales if customers do not see any added value with the price rise (high price sensitivity).
Profitability framework – Key takeaways
Profitability problems are frequent in consulting assignments. To solve a profitability problem:
- find the root cause using the profit formula
- use a tree structure
- go down one branch at a time and segment it
- quantify and look for trends
- locate the biggest driver
- find out why through qualitative analysis and additional analysis (e.g., using the 4 Cs Framework).