The ultimate goal of any business is to make more money than it spends. Several factors—including efficiency, resource management, and strategic decisions—can influence a company’s bottom line. As such, profitability is a key indicator of the health and success of any business.
What is Profitability?
Profitability is measure of a company’s ability to generate income relative to its expenses. When a business’s revenue growth outpaces its spending and operating costs, it is said to be profitable. Companies that are not making enough money are considered unprofitable and must make adjustments in order to become profitable again.
Profitability is measured in two ways: accounting and economic profitability.
- Accounting Profitability: Accounting profitability, sometimes referred to as net profit, is the measure of a company’s income after all expenses and taxes have been paid. It is calculated by subtracting total expenses from total revenue generated.
- Economic Profitability: Economic profitability measures the ability of a business to generate value for its customers relative to its costs. This is measured using economic value-added (EVA), which subtracts a company’s costs of capital from its income. Other factors like customer satisfaction, customer loyalty, and product quality can also be used to measure economic profitability.
Profitability is the main reason any business exists—without an excess of revenue over expenses, it cannot survive. Companies need to continually monitor and adjust their operations in order to remain profitable and stay ahead of the competition.
- Profitability Index: The ratio of a business’s net income to the invested capital used to generate that income.
- Return on Investment (ROI): A measure of a company’s financial performance that indicates how much money is earned in relation to the amount invested.
- Gross Margin: The difference between the revenue and cost of goods sold, expressed as a percentage of revenue.
- Net Margin: The difference between total income and total expenses, expressed as a percentage of net income.
Why Analyze Profitability?
Since profitability is a key measure of success, understanding and managing it is important for businesses. There are several benefits to analyzing profitability:
- Looking into net profitability helps companies understand their financial performance and identify trends that can help them make better decisions.
- By understanding the current state of a company’s profitability, businesses can decide whether or not investing in a new project or initiative will yield a positive business outcome.
- Breaking down the individual elements of cumulative revenue shows companies which of their core business activities are valuable and which aren’t, driving operational efficiency.
- Examining each aspect of a business and how it contributes to its bottom line can help managers adjust their approach and optimize profitability.
The profitability index (PI)—sometimes referred to as the profit investment ratio—is a measure of business performance that reveals how much it earns relative to the amount it invests.
It is also helpful in measuring differential profitability (i.e., the differences in profitability among different activities or investments) and can be used to compare investment opportunities.
The formula for calculating the profitability index is:
PI = (Present Value of Future Cash Flows / Initial Investment)
Investments with a higher PI are considered more attractive and profitable than those with a lower PI.
How to Measure Profitability
When measuring profitability, it’s important to remember that it is a relative concept—different business models have different levels of profitability.
For instance, Software-as-a-Service (SaaS) companies operate optimally at over 75% margins, while ecommerce sellers operate at a much lower 10% net profitability (on average).
There are two ways to measure profitability: Using profitability ratios and through profitability modeling.
The profitability ratios formula is the most basic way to measure performance. It is an an accounting formula that considers income, expenses and other factors to measure the performance of a company.
Common profitability ratios include:
Operating Margin measures a company’s ability to generate profits from its operations. It is calculated by dividing the company’s operating income (revenue minus expenses) by its total net sales.
Mathematically, it is expressed as:
Operating Margin = (Total Revenue – Total Expenses) / Total Revenue
Operating margin is a useful metric for comparing companies in the same industry and determining the overall efficiency of their operations.
A higher margin suggests that the company can make more profit from its operations, while a lower margin indicates that the company needs to improve its operational efficiency to be more successful.
Return on Assets
Return on Assets (ROA) is a financial ratio used to measure a company’s profitability and efficiency. It is calculated by dividing net income (profits) by total assets.
In accounting, it is expressed as:
Return on Assets = Net Income / Total Assets
ROA is an important metric for investors, as it indicates how well a company is able to generate profits from its available resources.
A high ROA indicates that the company is making efficient use of its resources, while a low ROA shows stakeholders that their resource allocation decisions may not be as effective.
Gross Profit Margin
Gross profit margin is an accounting metric used to measure raw profitability. It is calculated by subtracting the cost of goods sold from total sales, then dividing this figure by total sales across revenue streams.
To calculate gross profit margin, use the following formula:
Gross Profit Margin = (Total Sales – Cost of Goods Sold) / Total Sales
Gross profit margin is a useful tool for evaluating the efficiency of production and pricing strategies.
If a company has a high profit margin, it is generally more profitable than a comparable company in its industry that has a lower margin.
Conversely, if a company’s profit margins are too low, it may need to review its pricing and/or production strategies to increase profits.
Net Profit Margin
Also called the income margin, net profit margin is a financial ratio used to measure the overall profitability of a company. It is calculated by dividing net income (profits) by total revenue across all revenue streams.
The following formula is used to calculate net profit margin:
Net Profit Margin = (Revenue – Cost) / Total Revenue
Net profit margin paints a more accurate picture of a company’s financial performance. Since net profit subtracts operating and development expenses from total revenue, it reflects the company’s efficiency in converting revenue into actual profits.
Profitability modeling is an alternative profitability measure that incorporates trends and changes in the market, customer demand, product pricing and other factors that affect a company’s bottom line.
It uses data from previous years to project future financial performance for a given period. It also incorporates sales, cost of goods sold (COGS), overhead, debt, and other factors to help companies make more informed decisions about their future.
Profitability modeling takes a holistic approach to measuring business performance, making it useful in revenue management.
Profitability vs. Profit
Profitability and profit are closely related business terms, but they are not the same.
Profit is how much money a business has left over after its expenses, while profitability measures the efficiency with which that profit was earned.
Profitability is a more comprehensive metric than profit and provides stakeholders with information about whether or not their investments are generating returns.
Think about it this way: Any business can generate a profit, but only a profitable business can optimize revenue and sustain success long-term.
Profitability vs. Cash Flow
Profitability and cash flow are also closely related business terms, but they measure different aspects of a business.
Cash flow measures the amount of money coming into a company versus the amount going out. On the cash flow statement, cash inflows are listed as positive numbers, and cash outflows are listed as negative.
Profitability, by contrast, measures how much profit a company is able to generate from its available resources. It is calculated by dividing net income (profits) by total assets or total revenue, depending on the context.
When evaluating a business, cash flow rate is a more accurate reflection of its immediate financial health, while profitability is a better indicator of the company’s long-term success potential.
Strategies to Improve Profitability
Since profitability is based on formulas, there are specific strategies companies can use to improve it.
1. Automate wherever possible.
Among the many benefits of digital transformation is process automation. Now, more than one-third of businesses have five or more automated divisions.
There are several benefits to automation, and each of them directly results in greater profitability.
- Compliance issues that arise from keeping manual records and processes are reduced, saving money in fines and penalties.
- The time it takes to complete repetitive tasks is reduced, freeing up employees to focus on larger, more profitable projects.
- The relatively low cost of business software replaces the overhead cost of employing personnel to do the same tasks.
- Streamlined workflows and integrated technology drive operational efficiency and allow for more profitable processes.
- Reductions in human error prevent costly mistakes from improper data entry, accounting errors, revenue leakage, or countless other mistakes that may occur when relying on manual processes.
- Predictive analytics and data-driven decision-making help reduce the amount of guesswork in forecasting, budgeting, and planning.
Using automation, businesses are smarter, faster, more accurate, and leaner, meaning they can generate more revenue while spending less capital—a win-win in terms of profitability.
2. Optimize the customer experience.
The importance of the customer experience cannot be understated. In their Future of CX report, PwC researchers reported that 33% of customers would abandon a company after one bad experience, while 92% would do the same after two or three.
If an organization wants to be more profitable, it needs to focus on retaining its customers. There are numerous ways companies can improve the customer experience protect their bottom line:
- Use help desk software and AI chatbots to respond to customer inquiries faster and more accurately.
- Provide customers with a personalized experience, both online and off.
- Analyze customer feedback to improve products or services.
- Introduce loyalty programs to reward customers for repeat purchases.
- Make mobile use easy and secure across all devices.
- Consistently engage with customers to build relationships.
3. Prioritize recurring revenue.
Recurring revenue is one of the most stable and profitable forms of income for businesses, especially those in SaaS or subscription models.
With recurring revenue, customers stay on board for longer periods of time, resulting in more customer loyalty and higher customer lifetime value (CLV).
It’s also easier to budget when there is a predictable stream of revenue each month. As long as customers are happy and keep renewing, there is a steady source of revenue without the need to invest large amounts of money in connecting with new customers.
To guarantee revenue for a longer time, companies can even incentivize large annual payments by knocking one or two months off of the total cost.
On an individual level, this lessens annual profit margins. But it guarantees a larger amount of revenue over the course of a year, making it more profitable in the long run.
4. Focus on cost control.
Businesses should regularly audit expenses and pinpoint areas where money can be saved or put towards higher-priority initiatives.
Costs can be cut in a variety of ways, such as renegotiating contracts with suppliers, reducing overhead costs by going digital, or outsourcing tasks to more cost-effective third parties.
By controlling costs and allocating budget based on the most important objectives, businesses can make sure they are using their resources efficiently and effectively to increase profitability.
5. Invest in employee development.
Investing in employees is another key factor when it comes to profitability. By providing training and mentorship, businesses can increase employee loyalty and performance.
When employees are engaged and empowered, they are more productive, with higher job satisfaction leading to increased customer satisfaction.
This not only increases productivity but also drives customer retention rates—both of which can significantly increase profitability.
Profitability and Cost Management
Cost management is a business strategy and process that helps companies maximize their profits while minimizing wasteful spending. It involves creating plans, setting goals, tracking expenses, and analyzing data to identify cost-reduction opportunities.
The goal of cost management is to ensure that all expenses are properly accounted for and optimized to maximize profits.
By managing costs, businesses can reduce overhead and use those resources to invest in initiatives that drive growth and profitability.
How CPQ Helps Improve Profitability
CPQ (configure, price, quote) is a software solution designed to streamline and automate the pricing process for businesses. It is based on the concept of pre-defined product configurations and pricing rules that allow sales teams to quickly and accurately generate quotes for customers.
CPQ software makes businesses more profitable by speeding up the quote-to-cash process, reducing errors, and providing better visibility into pricing.
It also helps companies improve their cost management by allowing them to define product configurations and pricing rules that help control costs.
Using a CPQ platform, businesses can make more money faster. And they can do so with less overhead.
People Also Ask
Can you measure profitability through performance ratios?
Performance ratios are the easiest and most common ways to measure profitability. Ratios such as gross margin, operating profit margin, and net margin all give companies a good indication of how profitable they are. They each have their own specific uses, such as tracking income statements or calculating a business’s liquidity ratios.
What is the principle of profitability?
Profitability is the amount of money a business has earned after subtracting all of its expenses. This includes non-recurring expenses and overhead costs associated with running the business. It also includes hidden costs like opportunity costs, taxes, and the overall scalability of the business.
Why do we calculate profitability?
Profitability isn’t just for financial reports. Companies depend on profitability to measure performance and make decisions about where to allocate resources. Through performance ratios such as gross profit margin, net income margin, return on assets (ROA), and return on equity (ROE), businesses can measure the success, efficiency, and value of their operations in terms of profitability.