What is Profitability Analysis & Why is it Important? Plus Example

Profitability analysis is an important tool for Financial Planning & Analysis (FP&A) professionals looking to drive business results. Such analysis not only shows what business units or product lines within an organization are profitable, but also helps model what-if scenarios – such as how pricing, new products and mix changes would impact customer and line-of-business profitability. In short, profitability analysis generates important data about the performance of business units, product lines, strategic initiatives and more to enable collaboration required for effective decision-making.

What is Profitability Analysis?

Profitability analysis assesses an organization’s revenue streams in order to understand how they generate profit. It looks at sales, costs, and profit margins to find out which products or services bring in the most money. This helps companies make smarter decisions about where to spend their resources, how to price their products, and how to operate more efficiently. Profit analysis not only shows where the business is doing well but also points out areas that need improvement, ensuring the business stays financially healthy and competitive.

The Importance of Profitability Analysis

Profitability analysis is vital for businesses because it helps identify areas to reduce expenses and increase revenue. By analyzing the most and least profitable ratio areas, companies can focus on strategies that enhance overall profitability and ensure long-term financial stability and growth. Offering detailed insights into profitability also helps with informed decision-making in key areas such as pricing, cost management, and resource allocation.

Profitability Analysis Example

Let’s look at an example of profitability analysis. Consider a retail company that wants to analyze the profitability of its various product lines to determine which ones are the most and least profitable. The company sells three main product categories: electronics, clothing, and home goods. To conduct a profitability analysis, the company would follow these steps:

1. Revenue Calculation:

Electronics: $1,000,000
Clothing: $800,000
Home Goods: $600,000

2. Cost of Goods Sold (COGS):

Electronics: $600,000
Clothing: $400,000
Home Goods: $300,000

3. Gross Profit:

Electronics: $1,000,000 - $600,000 = $400,000
Clothing: $800,000 - $400,000 = $400,000
Home Goods: $600,000 - $300,000 = $300,000

4. Operating Expenses:

Electronics: $150,000
Clothing: $200,000
Home Goods: $100,000

5. Net Profit:

Electronics: $400,000 - $150,000 = $250,000
Clothing: $400,000 - $200,000 = $200,000
Home Goods: $300,000 - $100,000 = $200,000

6. Profit Margin:

Electronics: $250,000 / $1,000,000 = 25%
Clothing: $200,000 / $800,000 = 25%
Home Goods: $200,000 / $600,000 = 33.3%

Conclusion:

Electronics and Clothing have the same profit margin of 25%, but electronics generate a higher net profit.
Home Goods have the highest profit margin at 33.3%, indicating it is the most profitable product line relative to its revenue.

From this analysis, the company finds that while electronics and clothing contribute equally in terms of profit margin, home goods offer a higher margin of profitability. Therefore, the company may decide to focus more on promoting and expanding its home goods product line to maximize profitability.

Profitability Analysis for Analyzing Business Results and Modeling Future Scenarios

Simply put, profit is defined as revenue minus expenses. Despite being a common area of interest to Finance, revenue is not always the best metric for the health of a product line or business unit. Profitability analysis, however, can help the organization understand what areas are performing well and which may need more attention or need to be reevaluated.

Using profitability analysis not only shows how these areas are performing today and how they have historically performed, but also models strategies for the future. Profitability analysis can model what-if scenarios to determine how price changes, new products and mix changes could impact customer and line-of-business profitability. The impact these changes have on the P&L, balance sheet and cash flow statements can be modeled and reviewed across the organization. By pairing profitability analysis with powerful reporting and analytics capabilities, Finance can quickly monitor dashboards and easily share results of the analysis with key stakeholders. This will help them make better-informed decisions and adjust strategies ahead of month-end close when results impact the financials.

Profitability Analysis for Better Financial Results

Understanding what business units, product lines, and initiatives within an organization are profitable and which are struggling is key to efficiently and effectively allocating resources across the organization.

By analyzing the profitability of different product lines or business segments, for example, FP&A software can determine which products and services are most profitable. This will lead to better resource allocation, continuing to drive profit in areas generating it while helping areas that are lagging. Additionally, profitability analysis can help identify cost-saving opportunities by identifying where to reduce expenses or when to negotiate better terms with suppliers.

Analyzing which areas constitute the top 80% of profitability ratios (Figure 1) can help an organization better understand the drivers in the business and then allocate resources accordingly.

Profitability Analysis for Aligning Strategic Initiatives and Enterprise Goals with Profitability Results

In addition to showing which product lines and business units are performing, profitability analysis can help FP&A teams understand the performance of strategic initiatives. For example, the results of a new marketing initiative can be analyzed using profitability analysis to understand what's working and what's not. Finance can then make adjustments to improve performance.

Profitability analysis can also be used in the planning, budgeting and forecasting cycles by helping to identify the key drivers that forecast future financial performance. By analyzing past trends and identifying the drivers of profitability (Figure 2), Finance can more accurately forecast revenues, costs and profits.

By improving forecast accuracy and focusing efforts in the right areas, Finance provides a better guide for long-term planning and decision-making within an organization.

Profitability analysis is also an important tool for measuring a company's overall financial health. A business unit or product line showing increased revenue does not always indicate increased profitability. By analyzing key financial metrics such as gross margin, operating margin and return on investment (ROI), Finance can determine the overall profitability of business segments, product lines and initiative across an organization. These metrics can also be used to benchmark the company's performance against competitors, providing valuable insights into the company's market position.

Why Profitability Analysis Matters for Businesses

By analyzing profitability, Finance can identify which areas of the business are performing well and which areas need improvement. Additionally, profitability analysis can help evaluate the effectiveness of different strategies and tactics, forecast future financial performance and measure a company's overall financial health. Ultimately, profitability analysis matters because it identifies what segments of the business and product lines are actually profitable, not just generating revenue.

Learn More About Profitability Analysis

Want to learn more about OneStream's profitability analysis offerings? Check out our solution brief about Conquering Complexity in Profitability Analysis.

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FAQs on Profitability Analysis

How Often Should a Business Conduct Profitability Analysis?

The frequency of profitability analysis mainly depends on the type and size of the business. As a general rule, businesses should conduct profitability analysis at least quarterly, however more frequent analysis can provide more timely insights for decision-making.

What Role Does Profitability Analysis Play in Strategic Planning?

Profitability analysis plays a critical role in strategic planning. It provides detailed, data-driven insights into which areas of the business are most profitable and which ones need improvement. This information guides strategic decisions, such as investments, cost-cutting measures, and market expansion plans, to enhance overall profitability and achieve long-term goals.

What are the Top Uses of Profitability Analysis?

There are a number of uses for portability analysis which can help your business succeed. This can include:

Identifying Profitable Products/Services: Determines which areas gain the highest profits.
Optimizing Pricing: Helps adjust pricing strategies based on profit margins.
Cost Management: Highlights areas to reduce expenses and improve efficiency.
Resource Allocation: Guides allocation of capital, labor, and marketing efforts.
Strategic Planning: Informs decisions on market expansion, product launches, and operations.
Performance Benchmarking: Allows comparison against industry standards and past performance.
Investor Relations: Provides insights for communicating financial health to investors.
Budgeting and Forecasting: Helps with creating accurate budgets and financial forecasts.

What are Some Common Profitability Ratios Used in Profitability Analysis?

Common profitability ratios include the gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE). These ratios provide insights into various aspects of an organization’s profitability and operational efficiency.