Profitability Analysis Framework, pt 1 - High Level Overview

Profitability Analysis Framework Series
[ 1. Overview, 2. Fixed Costs, 3. Variable Costs, 4. Sales, 5. Price ]

As public corporations are profit seeking entities, one of the most common frameworks in use is the profitability analysis. Over the next week, I'll be posting about the different components that make up this analysis as well as some of the common challenges that arise and some solutions based on case studies of previous companies.

While the underlying math and mechanics of this discussion will usually be quite simple, what is more intriguing is the surprising relationships that surface as a result of an integrated and systematic analysis of the case studies. Most companies are unique (providing them with their own competitive advantages and challenges) however there are some common themes to learn from the cases which are applicable to any business environment.

We will review them as follows:

Part 1 - High Level Overview (This post)
Part 2 - Fixed Costs: Capacity and Investment Decisions
Part 3 - Variable Costs: Cost of Goods Sold
Part 4 - Sales: Volume, Brand Equity and Positioning
Part 5 - Price: Elasticity and Differentiation
Everyone is familiar with the basic formula for profit:

Profit = Revenue - Costs
(individual product lines)

Shareholders Equity = Assets - Liabilities
(symmetrical for companies at large)

Costs can be further subdivided into two categories:

Total Costs = Fixed Costs + Variable Costs

And similarly for revenue:

Revenue = Price x Quantity Demanded

While we have hardly made any ground breaking discoveries here, what should be highlighted at this point is the ability to ask the right questions when confronted with a declining profit scenario. It is important to understand what is happening in the competitive landscape such that profits are declining. By quickly identifying which area should receive attention we can systematically analyze the company's fundamentals to determine where changes are needed).

In Part 2, we will look at fixed costs and how they affect profitability as the need for more investment or more efficiently allocating capacity.

Profitability Analysis Framework Series
[ 1. Overview, 2. Fixed Costs, 3. Variable Costs, 4. Sales, 5. Price ]