Profitability is like the innermost core of an onion; it’s covered with layers over layers that reduce the size of the inner core. When the size of the whole onion is limited (revenue) it is important that the size and number of the layers are cut down, and what remains as the core (i.e. What you take away at the end of the day; PAT or Profit after Tax) is maximized.
To cut down on the costs it is most important to understand what the profit onion is composed of. We will try and decode this onion of profitability to understand the drivers behind it, more often than not you would realize it’s a trade-off between some of the drivers.
Return on Assets (ROA) is often considered as one of the best metrics used to measure profitability, having numerically huge profits don’t make sense if the assets put to work to generate them are disproportionately bigger. (We will use ROA to understand profitability in this article).
ROA can be broken down as a function of revenue, income, and assets.
Income is the difference between Revenue and cost
Ideally one would want to increase the price and volume while reducing the costs, but we know that price and volume are more often than not negatively correlated, increasing prices would decrease the number of customers/ reduce volume. Increasing volume may also increase total assets which would lower ROA.
These trade-offs leave managers with a wide array of choices they can look at
- Playing the price and volume game
It is important to know what is the best price point to operate in the industry, allowing you to out-position the competitors without compromising on margins too much and hence win on volumes as well as margins. An understanding of the Price elasticity in the industry goes a long way in improving the bottom line.
- Identifying the right product mix
Often a company has multiple sets of products that can have profitability as the sales of some of the products may be cannibalized by the other, there may also be a case that larger volumes of the less profitable product are being sold. A reconfiguration of the product and sales mix can yield a disproportionate benefit in product mix.
One of the most popular strategies for increasing profits (yet as per research the least effective), a straight forward way to improve your profit would be to reduce costs, but cost reduction measures have shown to correlate with subsequent poor performance. Cost-cutting is not a viable measure in the long term. Cost-cutting as a strategy to stay profitable was the rarest one among the well-performing businesses.
Assets being the denominator for the ROA, reducing the asset base can help you increase the ROA, reducing asset base does not mean reducing capacity, but rather a large number of activities are outsourced.
The world has seen a trend of a large number of asset-light companies, (OYO doesn’t own any hotel properties, Uber doesn’t own any cars) these companies have given the best returns (at a unit economics level) this is because of a smartly managed asset base. And a few clients have also come to us with the requests of turning asset-light.
A low asset base reduces additional costs that come along with an expansive set of assets.
Industry studies, Academic research, and our experience from working with clients have shown that for most of the highly profitable companies, the profit is driven through revenue and revenue related measures. Most of the large, exceptionally well-performing companies drove their advantage through revenue rather than lower costs. This research has shown that it is more sensible to seek higher profits by increasing your revenues rather than reducing COGS. And the way to increase this revenue is to generate a price premium (be capable of commanding a higher price).
Improving unit price is most frequently the strategy employed by such large companies to drive their profits, research has shown that the price component was the primary driver for gross margins. Most companies that perform best (best returns, consistent performers in stock markets) seek to improve their profits by charging a price premium, this ensures that they are profitable at a unit level, and with even low volumes they are able to outperform most other companies.
- Yet beyond this, there is a cost-control approach,
This approach is slightly different from a cost-cutting approach, here rather than trying to haphazardly reduce the costs by reducing the inputs, it involves a detailed analysis of the major heads of your P&L and rationalizes them with an understanding of how the benchmark performers operate in the industry.
The major heads for costs are often
– controlling the material consumption goes a long way in controlling costs, the material consumption maybe often close to half of the revenue you earn, small savings in material consumptions can create large profits.
Some of the ways to achieve this could be, working with clients who yield the best margins, a detailed sales analysis can reveal which are the clients are actually adversely affecting material consumption. Attempts to refocus the efforts and capacity of more profitable clients would improve profitability.
– This would be one of the major costs for the services industry, an HR analysis can help you understand if you are overstaffed, or are overpaying for the same output.
An aging group of employees can also be a drag on the profits, employees who have been in the organization for a long time see their salaries balloon, but they may haven’t grown in terms of the outputs they produce and hence incur a disproportionate cost.
While looking at the employee costs you also need to look all the other associated costs with having employees, it may often be best to outsource some non-core activities and not have employees on your book hence reducing multiple layers of costs
– Your administrative expenses speak a lot about the quality of management, maintaining tight control on frivolous expenses is important, or there are chances that your costs spiral out on the pretext of administrative expenses.
Repairs and Maintenance
– As seen from working with a large number of our clients, another major cost they incur is for repairs and maintenance, this is usually due to a one-time maintenance activity they take up or a major breakdown that comes their way. One of the best ways to control this cost is to carry out preventive maintenance on your fixed assets regularly or one-time maintenance creates multiple problems in terms of downtimes and disproportionate costs.
One good measure for the same is to enter into an Annual maintenance contract, where the AMC contractor will take up the liabilities for breakdowns hence saving you the costs.
At MARC we look at all of the above considerations in our profitability analysis and help you devise the best strategy to improve the performance of your organization. We combine it with our expertise in developing SOPs, Human resource management, and Market research to give you the best outputs.
Feel free to get in touch with us to discuss your business’s profitability a small action now can go a long way in boosting the bottom line.