The amount that is left after a business has paid all expenses, is known as profit. There are factors that affect profitability of a business. Some of these profitability factors of a company can be controlled whereas others are a little bit hard to control. Hence, companies make use of certain profitability indicators in order to analyze the profit level of their business and focus on the profitability factors that can be controlled to improve profit. This is needed because gaining control of some of these factors and analyzing them regularly will enable a business to make the needed changes in order to maximize the company’s efforts toward making a profit.
There are several factors of profitability such as competition, price, state of the economy, variable costs, the strength of demand, etc. In this article, we will be discussing these profitability factors, but first, let’s address what profitability is in business.
Understanding profitability in business
In business, profitability is essential for survival because a company can’t stay in business if it doesn’t stay profitable. A business is said to be profitable when its revenue is more than its expenses. Hence, profitability in business is the revenue from operations, less the expenses. When a business’s expenses are deducted from the revenue generated from the business activities, and the result is positive, it means the business is profitable. This means that, the greater the result, the more profitable the business is. However, if the result is a negative result (loss on the income statement), it means the business is not profitable.
The main factor for the profitability of a business is revenue from sales of products or services. Nevertheless, making money on sales generates income, but doesn’t necessarily make a business profitable. Profitability relates to the business’s income, and not necessarily its cash flows. Hence, if a business is recording its transactions under the accrual basis of accounting, it is quite possible that the profitability condition of the business will not be matched by the cash flows generated by the business, since some accrual-basis transactions (like depreciation) do not involve cash flows.
Therefore, profitability is a situation in business, whereby a firm is generating a profit. It occurs in business when the aggregate amount of revenue is greater than the aggregate amount of expenses in an accounting reporting period. Also, the profitability of a business can be achieved in the short term through the sale of assets that remit immediate gains. Nonetheless, this type of profitability is not sustainable. Hence, a business must have a business model that allows its ongoing operations to generate a profit, or be at risk of failing eventually.
Profitability is one of the metrics that can be used to derive the valuation of a business. Therefore, increasing profitability in business is a long-range goal of most small-business owners and entrepreneurs. This is because greater profitability signifies more money for the business and any other investors. As a business owner, it also lets you build up a cushion against competitors undercutting you, vendors increasing prices, or economic downturns.
Generally, there are factors affecting profitability such as demand for a company’s products, the cost of making these products, the general economy, and the competition that the company faces. Therefore, understanding and working on the profitability factors in a business as well as measuring your business’s profitability from time to time is essential for a successful business. Profitability can be measured with a variety of ratios like the profit margin, net profit ratio, return on assets (ROA), and return on equity (ROE). Others include return on invested capital (ROIC), earnings per share ratio, and return on capital employed (ROCE). For instance, the net profit ratio compares after-tax profits to revenues, whereas the earnings per share ratio show profits on a per-share basis.
Types of profitability factors
- Variable costs
- Fixed Costs
- Degree of competition
- Strength of demand
- Relative costs
- Exchange rate
- State of the economy
- Advertising and marketing campaign
- Economies of scale
- Price discrimination
- Objectives of firms
Profitability factors are the factors that affect the profit level of a business or firm. Let’s look at some of these factors that affect the profitability of a business below:
Price as a profitability factor
Price is a profitability factor because it is what a business is charging for the products or services that it delivers to customers. Therefore, it happens to be the first factor that determines profit. There is quite a catch that goes into developing a business’s price point. The goal is to charge as much as the business can for what it is producing, as long as it is still competitive. The price of a business’s product or service definitely plays a role in its profitability. Hence, when setting a price, there are two perspectives that a business has to consider for profitability’s sake.
First, a business has to look at its building-up method. How much it costs to be in business and how much it costs to deliver a service has to be put into consideration. When considering increasing the pricing for a product or service, all of the costs associated with doing business (raw materials, time, etc.) must be put into consideration to ensure the price covers the cost.
Secondly, when setting a price, the business has to consider the current market rates. What is going on in the business’s industry as well as what its competitors are charging has to be put into consideration when it comes to setting a price. There is a tension between a firm’s internal costs and the market rates and so a firm must find a happy medium that yields the highest profit for its business while also remaining competitive. Hence, in determining what the landscape of one’s business industry is, marketing research can be quite helpful.
Furthermore, when it comes to profitability, a business’s pricing strategy is an essential tool. A business has to differentiate itself, either by choosing to charge a premium or by establishing itself as a low-price leader. Hence, how a business charge for its goods or services is one of the profitability factors that affect how it makes a profit.
Variable costs are one of the factors that affect profitability of a business. These are the costs that change with revenue such as the cost of labor, utilities, commission, distribution, and raw materials. Such costs will increase as revenue increases and are a central part of determining a product’s contribution margin; the measure used to determine a company’s break-even or target profit level. Hence, it is important to have a good understanding of the relationship between these costs.
Having awareness of these costs, how they move, and what things drive them, enables businesses to make decisions about what they’re going to do when it comes to profit. In business, one has to have an understanding of the effects on the cost side with every action that is taken. Variable costs are one of the factors affecting profitability. If for instance, a change is made to the top-line figure (revenue) without considering the effects of the costs, then a business may not get the intended results.
For example, if management chooses to add a large number of clients in order to increase profit, it has to consider the costs associated with taking that action. The management has to consider how many more team members or administrative staff would be needed to serve the new clients. That is, the management has to consider what the cost to obtain those new clients would be because it is not reasonable to get 100 more clients if the bottom line isn’t going to increase the way that it is expected to. It would just be creating more havoc without results.
Therefore, fully understanding the business’s variable costs, would enable you to consider other ways to increase your profit. This means that variable costs as a profitability factor would play an important role in having the impact you want on your profit levels. This is why variable costs determine margins and net income. Hence, gross margin, profit margin, and net income calculations are usually calculated with a combination of fixed and variable costs. Therefore, by performing variable cost analysis, a business can easily identify how scaling or decreasing output can impact profit calculations.
Fixed costs as one of the profitability factors play a role in price points which is an important factor for profit. Fixed costs stay pretty stable regardless of the business’s revenue. Hence, they are the cost of a business expense such as rent, overhead items, interest payments, and insurance that doesn’t change even when there’s an increase or decrease in the number of goods or services sold or produced. They are commonly related to recurring expenses that aren’t directly related to production.
Therefore, you have to be very familiar with these costs because they will play into price points. That is, when setting a price, you want to ensure you’re including enough to cover the fixed costs to enable profitability. By considering fixed costs and understanding if they are going to be increasing, you can usually foresee changes in these costs and make any necessary changes as needed.
Furthermore, fixed costs as a profitability factor are considered an entry barrier for new entrepreneurs. Therefore, in marketing, it is important to know how costs divide between variable and fixed costs. This distinction is essential in foreseeing the earnings generated by various changes in unit sales as well as the financial impact of proposed marketing campaigns.
Degree of competition as a profitability factor
The degree of competition that a business faces is one of the important factors of business profitability. Competition is one of the very strong profitability factors that affect the profitability of a business. If a business has monopoly power then it has little competition, which means that demand will be more inelastic. This will enable the business to increase profits by increasing its price. Profitable firms, such as Google and Microsoft as a typical example have developed a degree of monopoly power, with limited competition.
However, in theory, government regulation such as OFT (Office of Fair Trading) may prevent monopolies from abusing their power. This regulatory body can stop firms from colluding (to increase prices), for instance, regulators like OFGEM (Office of Gas and Electricity Markets) can limit the prices of gas and electricity firms.
On the flip side, if the market is very competitive, then the profit that a business will make will be lower. This is because most consumers would prefer to buy from the cheapest firms. Also, another important factor in competition is the idea of contestability. Market contestability is how easy it is for new businesses to enter the market. If entry is easy then already existing businesses will always face the threat of competition (even if it is just a hit-and-run competition) which will reduce profits. Therefore, competition is one of the factors of profitability.
Strength of demand
The strength of demand is one of the profitability factors of a business. The law of supply and demand is a fundamental economic principle that states that when supply exceeds demand for a good or service, prices fall and when demand exceeds supply, prices tend to rise. Therefore, if the strength of demand is weak, prices will fall which leads to less profitability for a business and if the strength of demand is strong, prices will rise which leads to more profitability. Hence, the strength of demand serves as one of the profitability factors.
For instance, if a product is fashionable, demand will be high. For example, mobile phone companies were profitable during the period of rising demand and growth in the market. Whereas, products like Spam (tinned meat) which have falling demand will lead to low profit for the company. Also, some companies, like Apple, have succeeded in carving out strong brand loyalty, which makes customers demand many of the new Apple products. Furthermore, if there are many substitutes that are expensive, compared to a business’s product, then the demand for the product will be higher. Similarly, complementary goods will be essential for the profits of a company.
Relative costs as one of the profitability factors
Relative costs play a role as one of the factors affecting profitability of a business. As a profitability factor, an increase in relative costs will decrease profits. Relative costs could include labor costs, raw material costs, and the cost of rent.
Take, for instance, a devaluation of the exchange rate that could increase the cost of imports, which causes companies that import raw materials to face an increase in costs. That is, if the exchange rate faces devaluation, the cost of imports will skyrocket which in turn will lead to companies using imported raw materials to bear higher production expenses.
Therefore, if the production costs of the company such as rent, raw material, and labor increases, its profits will inevitably be lowered. On the other hand, if the company can introduce new and improved technology (such as CRM software) in order to enhance its growth, the profits will also increase simultaneously.
The exchange rate is also a profitability factor because if a company relies on exports, a depreciation in the exchange rate will increase the profitability of the company. That is, a fall in the exchange rate makes exports cheaper to foreign buyers. Hence, the company can sell more or choose to have a bigger profit margin. On the flip side, if the company imports raw materials, a depreciation will increase the costs of production which will decrease the profitability of the company.
State of the economy
The state of the economy is one of the most crucial profitability factors. It has a role to play in the profitability of a business. This is because, during seasons of economic growth, you find out that consumer confidence is high, unemployment rates are low and people tend to have greater disposable income. All of this leads to more people patronizing businesses which increases the profitability of the business. There will be increased demand for most products, especially luxury products if there is economic growth with a high-income elasticity of demand.
Hence, the effect of economic growth on business is incredibly positive as businesses are likely to earn more customers, increase profitability, and experience great opportunities for further growth and expansion. On the other hand, during an economic downturn, jobs are cut, and people tend to save more. Hence, businesses are likely to feel the pressure. For instance, in times of recession, manufacturers of luxury sports cars will suffer but when there is economic growth, they tend to benefit. Therefore, the state of the economy is crucial as economic growth leads to increased revenue and profitability, which can create some great opportunities for businesses.
Advertising and marketing campaign
Advertising and marketing campaign is one of the factors affecting the profitability of a company. This is because a successful advertising campaign can increase demand and give a product more inelastic demand. Nonetheless, the increased revenue will need to cover the costs of advertising. Hence, one must ensure that the increased revenue is able to compensate for the expenses towards marketing. This is why sometimes the best marketing strategy is word of mouth.
A business’s marketing campaign and its ability to strike a chord with its potential customers play a vital role in determining its business profitability. An appealing and compelling advertising campaign will always spread the word and attract potential buyers to a brand which increases profitability. There are a lot of marketing strategies that small businesses can use to increase their profitability such as content marketing strategy, societal marketing, inbound email marketing, etc.
Economies of scale
Economies of scale are one of the factors of business profitability. They are cost advantages reaped by companies when production becomes efficient. Generally, the size of the business matters when it comes to economies of scale. The larger the business, the more cost savings. Hence, by increasing production and lowering costs, companies can achieve economies of scale because costs are spread over a larger number of goods.
A company with high fixed costs will need to produce a lot to benefit from economies of scale and produce on the minimum efficient scale, otherwise, the average costs will be too high. For instance, in the steel industry, we have seen a lot of rationalization where medium-sized firms have lost their competitiveness and had to merge with others. Hence, economies of scale are important because they can help provide businesses with a competitive advantage in their industry which will increase their profitability.
Price discrimination is a profitability factor that exists in some businesses. This is a selling strategy that charges customers different prices for the same product or service based on what the business thinks they can get the customer to agree to. If a business can price discriminate, it will be more efficient in increasing its profitability. This is because it is charging different prices for the same good giving the business room to charge higher prices for those with inelastic demand. This is usually important for airline firms.
Management plays an important role in the profitability of a business and as such would count as one of the profitability factors. For the long-term growth and profitability of a business, successful management is very important. A business cannot grow without a strong team of managers striving hard to push it forward. Therefore, smart business management is key for the long-term growth and profitability of a company.
Proficient managers would incorporate their leadership skills to ensure the timely completion of projects, and also motivate their team towards achieving the company’s targets. On the flip side, inefficient and careless management (such as poor decision-making) will cause a decline in workers’ morale and indirectly contribute to lower productivity and decreased profitability. For instance, poor management that results in a decline in worker morale will harm customer service and worker turnover.
Objectives of firms
The objectives of a business or firm are vital for profitability. Not all businesses are profit-maximizing. Some businesses may just seek to increase market share and in such cases, sacrifice profits in order to gain market share. Hence, a business’s objective is one of the profitability factors.