Profitability Framework

At its simplest, profit is the difference between the amount earned and the amount spent in producing or selling something. It is one of the most important metrics of any business.  Profit is the key to business survival. For most organisations the generation of profit allows them to make further investments, pay dividend and rewards to staff and investors, and it provides a buffer for when times are hard.

Profit is a general word referring to the gain that has been achieved when all costs are subtracted from the sales. 

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Gross profit is what is left after the cost of making the product (cost of sales) has been deducted. In other words after subtracting the variable costs of raw materials, manufacturing costs, labour etc.  

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Net profit is arrived at after making a further subtraction of fixed costs such as administrative expenses, advertising, rent, sales costs etc.  

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Most business to business companies watch their gross profit very carefully. This is sometimes called the sales margin or gross margin and it is calculated as:

It is useful to have standards by which you can determine whether you are managing your company efficiently. A gross margin of around 60% is considered excellent for most companies.

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Of course, it is still important to also keep an eye on overheads and make sure they don’t run away.

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After taking into consideration all costs – variable and fixed – most companies make between 10-15% net profit before tax.

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At its simplest there are only three ways to increase profitability.

1. sell more products,

2. increase prices

3. reduce costs.

These principles can be shown as a framework:

Increasing profits by selling more isn’t always easy. It has to be assumed that you are already working hard to maximise sales.  So, too it isn’t always easy to cut costs – they are what they are. There may be an opportunity to increase prices. This is always a concern as it could inhibit sales. However, even a small price increase such as 1% can make a big different. For example, a 1% increase in price for many companies will go straight on the bottom line and add around 8% to net profits.

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This is a discussion on profitability frameworks and there is another profitability measure that you should be familiar with. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA gained popularity as a financial metric in the 1980s and 1990s, particularly in the context of leveraged buyouts (LBOs) and mergers and acquisitions (M&A). The increased use of EBITDA was driven by financial professionals and investment bankers who sought a measure that could provide a clearer picture of a company's operating performance and cash flow potential.

The formula is represented as follows:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

The measure is often used to assess a company's operating performance, as it focuses on its core profitability without the impact of financing decisions or accounting practices. It allows for easier comparability between companies and industries by removing the effects of different capital structures, tax rates, and accounting methods. It is considered by some as a proxy for cash flow. It can be useful in assessing a company's ability to generate cash before considering the impact of interest and taxes.

However, EBITDA faces criticism as it excludes certain crucial expenses, such as interest and taxes, which are essential components of a company's financial obligations. Also, it does not account for capital expenditures (CapEx), which are necessary for maintaining and growing a business. Therefore, it does not provide a complete picture of a company's financial health.

There are some other things to think about when aiming to increase profits: