essay on profitability analysis

Corporate Valuation pp 217–256 Cite as

Profitability Analysis

• Benedicto Kulwizira Lukanima 2  
• First Online: 05 August 2023

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Part of the book series: Classroom Companion: Business ((CCB))

Profitability is the most important performance measure used in business operations. Although it does not imply value, profit maximization signifies investment returns (interest and dividends paid to debtholders and shareholders) and growth potential (retained earnings). Therefore, investors and other users of financial statements tend to be more attentive to news about profitability than other financial metrics, thus making it the most important ratio in financial analysis. This chapter, therefore, takes a special interest and focuses on the key profitability ratios, aiming to demonstrate their implications in corporate valuation.

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Bibliography

Buffet, W. (1993). To the Shareholders of Berkshire Hathaway Inc., https://www.berkshirehathaway.com/letters/1992.html Accessed March 03, 2021.

Jiang, B. & Koller, T. (2006), A long-term look at ROIC , Available at McKinsey https://www.mckinsey.com.br/business-functions/strategy-and-corporate-finance/our-insights/a-long-term-look-at-roic Accessed February 01, 2006.

Kovar, J.F. (2020). M&A Adviser To Solution Providers: To Boost Valuation, Get To 50 Percent Recurring Revenue, Available at CRN https://www.crn.com/m-a-adviser-to-solution-providers-to-boost-valuation-get-to-50-percent-recurring-revenue Accessed March 03, 2020.

Scuttlebutt Investor (2016). A good metric is hard to find—return on capital, http://www.scuttlebuttinvestor.com/blog/2016/12/10/return-on-capital-and-other-diversions Accessed December 17, 2016.

Stern J. M, Stewart, B.G, Chew, D. H (1995), The EVA Financial Management System, Journal of Applied Corporate Finance , 8(2), 32.46. https://doi.org/10.1111/j.1745-6622.1995.tb00285.x

Trainer, D. (2019), Long-Term Trends Revealed by Analyzing ROIC By Sector, Available at Forbes, https://www.forbes.com/sites/greatspeculations/2019/06/19/long-term-trends-revealed-by-analyzing-roic-by-sector/?sh=7bfbe4b92e87 Accessed June 19, 2019.

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Kulwizira Lukanima, B. (2023). Profitability Analysis. In: Corporate Valuation. Classroom Companion: Business. Springer, Cham. https://doi.org/10.1007/978-3-031-28267-6_7

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Profitability Analysis: Microsoft Inc Vs Apple Inc Essay Example

Type of paper: Essay

Topic: Business , Finance , Investment , Internet , Company , Wealth , Steve Jobs , Commerce

Words: 1000

Published: 03/30/2020

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Profitability Analysis: Microsoft Inc

i) Profit Margins: Referring to the profit margin ratios of the company, we can infer that the fiscal year of 2013 was favorable for Apple Inc with 5.05% increase in profit margins of the company in comparison with the previous year of 2012. The company has improved its net profit margins after its fall in 2012. The improvement in the profit trend of the company seems sustainable as the increase in profit margins of the company was attributable to fall in operating expenses of the company. Although during 2013, the proportion of cost of revenue to the sales was increased from 24% to 26%, but Microsoft Inc was successful in reducing the proportion of operating expenses to sales from 46.70% to 40%. Furthermore, increased proportion of operating income from 30% to 34%, improved the bottom line profits of the company. By the end of the fiscal year of 2013, Microsoft Inc had recorded a 29% increase in its profit margins. ii) Return on Assets: Just as the profit margins, the company was successfully able to improve its Return on Asset Multiple. During the year, the ROA multiple of the company has improved by 1.35% after suffering significant decrease during 2012. Increase in ROA multiple of the company was attributed to increase in net profit margins of the company and increase in total assets figures. As already discussed in the previous section, the profit margins of the company increased by 28%, with 17.5% increase in total assets figures, it was able to increase its ROA multiple in a sustainable manner. iii) Return on Equity: After significant fall in 2012, the ROE multiple of the company, during 2013, has improved marginally from 25.58% to 27.69%. Although, the equity investors of the company might be relieved with this outcome but they would be still expecting a higher ROE. The increase in ROE multiple was achieved with 28% growth in the net income of the company and 19% increase in shareholder equity value i.e, net 9% growth to increase ROE.

Conclusion:

The analysis of profitability ratios of Microsoft Inc indicates that the financial position of the company has improved from its poor performance during 2011-2012. The Net profit margins, ROA and ROE multiple of the company has increased in a sustained manner primarily with growth in net income of the company. However, the investors of the company shall be expecting ROE levels of 2011.

Du-Pont Decomposition:

ROE: Net Profit Margin*Asset Turnover* Equity Multiplier ROE: (Net Profit/Sales)*(Sales/Assets)*(Assets/Shareholder Equity) Net Profit Margin: 0.28 Asset Turnover: 77849/142431*100= 0.5465 Equity Multiplier: 142431/78944*100= 1.8 Thus, as per Du-Pont Decomposition, ROE= .28*.5465*1.8= 27.54% So, our analysis indicates that major contributor to increased ROE multiple is equity multiplier while net margins have a very small portion in ROE of the company. This means that the things can get more risky in Microsoft Inc as the company seems to be over-leveraged now.

Profitability Analysis: Apple Inc

i) Net Profit Margin: Referring to the above analysis for Apple Inc, the company has reduced profit margins during 2013. During the year, the net margin of the company was recorded to be 21.67% which was 5% less than the previous year. Although the profit margins of the company improved during 2012, but with high cost of sales and decreased non-operating income of the company, the profit margins declined during 2013. While the proportion of cost of sales to revenue of the company increased from 56% to 62%, the share of non-operating income decreased from 36% to 29%. Thus, although the company was successfully able to maintain the proportion of operating expenses at 9%, but the above discussed factors forced the decline in net profit margins of the company. ii) Return on Assets: Just as the profit margins, the ROA multiple of the company has also declined during 2013 from 23.70% to 17.89%. The decline in ROA multiple of the company was attributed to increase in total assets by 17.56% which was further supported by decline in net margins and resulted in low ROA multiple.iii) Return on Equity (ROE): Investors of Apple Inc will not be satisfied with financial results of 2013 as the ROE of the company has decreased significantly during 2013 from 35.30% to 29.98%. Just as previously discussed profitability ratios, even ROE of the company was affected with declined net profit margin. Hence, 5% decline in profit margins and 4.5% increase in shareholder equity, together contributed in declining ROE of the company.

Our above analysis indicates that 2013 was not a good financial year for Apple Inc. All of its profitability ratios were in declining trend because of decreased net profit margins. As a result, both ROA and ROE multiple experienced decreasing trend indicating inefficiency of Apple Inc’s management to generate margins from the funds invested in the assets and for the investors of the company. ii) Du-Pont Analysis:

ROE: Net Profit Margin*Asset Turnover* Equity Multiplier

ROE: (Net Profit/Sales)*(Sales/Assets)*(Assets/Shareholder Equity) Net Profit Margin= 21.67% Asset Turnover= 170910/83451= 2.04 Equity Multiplier= 83451/123549= 0.67 So, ROE= .2167*2.04*.67= 29.61% Above Du-Pont analysis indicates that although the profitability margins of the company were on declining trend during 2013 but the ROE multiple of the company is sustainable with high net margins and high asset turnover contributing to the major portion to the ROE multiple.

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What is profitability analysis?  

Profitability analysis is a crucial tool in management accounting and credit underwriting, allowing businesses to evaluate the profitability of individual customers or customer segments . It helps in assessing if investments are yielding advanced returns, operational efficiency, and the effectiveness of human resources within a company . Profitability is not only about making a profit but also ensuring high profitability in economic activities, reflecting the efficiency of resource utilization and overall business success . In the banking sector, profitability analysis plays a vital role in assessing the financial performance of public sector banks, highlighting factors like net profit margin, return on net worth, and capital adequacy ratios for enhancing overall profitability and survival .

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• Profitability of a Company Analysis

Profitability of a Company Analysis - Essay Example

• Subject: Business
• Type: Essay
• Level: Undergraduate
• Pages: 2 (500 words)
• Downloads: 2
• Author: newtonrenner

Extract of sample "Profitability of a Company Analysis"

These factors also help the company to gain a competitive advantage in the market and to maintain its goodwill and credibility in the market.

It is the form of the corporate strategy adopted by the company to increase the profitability and market share of the firm by increasing its sales volume by expanding and diversifying its products and services as well as by opening new gates of profitability in new markets. It can occur at any level in a firm either at the single unit level in a business or a corporate level. At the business unit level, the firm would expand its operations into the new market by creating a new segment in the specific industry that the firm was already in. However, at the business level, the diversification of the firm includes the investing strategy. In this strategy, 3M would analyze the market situation to make sure either to invest in any promising business or to penetrate the market by creating a new segment for the expansion of the business and to gain a competitive edge over the other companies within the same industry.

As we know that vertical integration is the process of merging two businesses that involve different stages of production (Harrigan). If 3M would adopt this strategy of vertical integration with the other business excelling at different production levels; would enhance 3M’s capability and performance. As well as, it would help the company to control its costs, units of production, quality of the products, and delivery structure.

Strategic Alliance is the kind of approach used by organizations to form a corporate relationship between them. In this kind of relationship, a firm develops a strategic alliance with another firm to meet shared goals, needs, and objectives. Companies can strategically alliance with other companies for anything from benefiting with resources such as products to using the distribution channels, expertise, knowledge, machinery, and many more. Forming a strategic alliance with the other companies in the market would benefit 3M and its partner firms in fulfilling the goals, benefiting each other as well as it would help the companies to become more attractive to competition by the other firms.

In M&A strategy, the firms grow or expand in the same sector by acquiring or merging with the other firm to acquire, divide or merge with one or different operations within the firm. This strategy would benefit 3M to either merge or acquire with the other firm doing the same business in the industry. It would help the company to grow, expand its business processes or units, and to benefit from the knowledge, expertise, or production of the other company.

Divestment is the reverse of the investment. It is the corporate strategy in which the company fulfills its financial or social objectives or needs. Divestment would benefit 3M if the company wants to overcome its financial losses by divesting its particular subsidiary to remain focused on the core business of the firm.

Adopting all of the above discussed or any one of the strategies would help the company to grow its operations in the market. This would help the company to overcome its losses, and its weak areas and to remain ideally competitive in the market.

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Home  >  Customer Value Optimization  >  Customer Profitability Analysis – benefits, guide, and ideas for improvement.

Customer Profitability Analysis – benefits, guide, and ideas for improvement.

• Article last updated: April 2, 2024
• Article first published: January 17, 2023

Table of Contents

Who brings in the most revenue for your company? Which customer is costing you the most? Are those customers that cost a lot worth it? Or are you wasting your resources catering to shoppers who aren’t even bringing considerable profits? All these answers (and many more) reveal themselves to you at the end of a successful Customer Profitability Analysis (CPA). Understanding Customer Profitability is an excellent step toward becoming more profitable in the long term.

This blog post will highlight this fantastic tool, including its formula, benefits, and the mindset you need to improve it.

What Is Customer Profitability Analysis? 

Customer Profitability Analysis  (CPA)   is finding the profitability of each customer (or customer segments) by attributing profits and costs to each separate customer (respectively, each segment) over a certain period.

According to the Customer Profitability Analysis definition, CPA is more of a management accounting tool than a marketing strategy. 

Benefits of Customer Profitability Analysis

Evidently, profitability is the endgame for your business, and there are multiple ways to increase your net margin. Some companies decide to focus on the first part of the journey and pump more prospects into the funnel, hoping to increase their profits. 

However, with the current surge in acquisition costs, you might find that acquisition is not necessarily sustainable.

After all, it’s not 2019 anymore.

When the acquisition isn’t returning a satisfying ROAS, the other approach to reducing marketing costs is getting your newly acquired customers to spend more with your store. I.e., increasing Customer Lifetime Value and growing in a predictable, healthy way. 

• CPA empowers you to better prioritize your retention efforts. 

With Customer Profitability Analysis, you can divide your customer base into customer segments based on  the value each customer generates . 

This segmentation is an advanced segmentation technique, also known as RFM (Recency, Frequency, Monetary value), that allows you to concentrate your efforts where it matters the most.

Of course, no one says you should completely ignore low-value customer segments. Yet, when resources are scarce and operations costs are getting higher and higher, it’s wise to direct your attention toward more profitable segments. 

When you segment your customers by profitability, you discover low-value groups that cost you more than they bring in. It’s common sense to let these customers loose and not stress too much over retaining them – freeing up your resources for power customers. 

• CPA optimizes your marketing strategies. 

Besides helping you eliminate (or simply let the natural customer churn occur), with CPA, you can update your marketing efforts by looking at your data.  

After identifying high-profit customers, you can conduct qualitative and quantitative research to uncover their traits, motivations, and needs. You can adjust your messaging, communication channels, and paid media strategy with these valuable insights.

This step aims to uncover as much information as possible about your most profitable customers, then work on attracting similar high-revenue customers.

• CPA helps you with customized retention strategies.

Analyzing customers and their value empowers you to do more than the bare minimum with your retention efforts.

Some businesses bribe their customers with discounts and vouchers without considering their wants and needs.

Different types of customers require various incentives – and as we discussed earlier, some of them aren’t even worth retaining. Customer Profitability Analysis gives you a better image of the costs involved in building customer loyalty and how much you can afford to spend on retention.

Use CPA to tailor your retention strategies according to customer value. 

Higher-profit customers will get the highest quality services. Even if customer service costs are higher, they will pay off in the long run when you see your investments returning.

• CPA helps you optimize and even reduce costs

A crucial step in CPA is determining how much each customer is costing you in customer service, marketing, and even product delivery. 

Of course, this insight is invaluable, as it shows you how much you spend in order to earn. 

A firm understanding of your costs enables you (and your teams) to identify opportunities for cost optimization. 

For example, companies offering free shipping in remote areas might find that those customers aren’t so valuable – as they don’t bring in much revenue. So, they can optimize the costs by not covering the delivery anymore and offering other perks, like discounts for future purchases.

Or you might find that specific customer segments cost you more in customer care, but they don’t bring as much value as other segments. 

This way, you can cut costs by offering alternative ways of contacting you without getting through an agent or prioritizing the tickets coming from high-value customers.

How Do You Calculate Customer Profitability?

So, you’re now convinced to calculate customer profitability and use the findings to adjust your customer segmentation, marketing strategies, and retention techniques.

Let’s move on to the customer profitability formula and bring more light to this fascinating tool. 

Customer profitability formula:  Total annual revenue generated – Total costs included.

In other words, you deduct the costs of acquiring and retaining the customer from the total revenue generated by said customer.

It’s essential to only include costs that you can directly attribute to a single customer. Don’t include operational or logistical expenses like rent, utilities, or manufacturing.

Suppose your eCommerce business sells $350 in products to a particular client monthly while also spending an average of $300 in acquiring and keeping the said customer. In this case, the formula would look like this:

CPA = $350 – $300 

This is the best-case scenario, where profitability is positive. But now, let’s look at the alternative. 

You spend approximately $400 in acquiring and retaining a customer who spends an average of $150 on your brand. In this case, the formula reveals a fascinating insight: 

CPA = $150 – $400

CPA = $-350

The CPA is negative, so this customer is a low-profit customer. This means you can either get them to spend more and push them into a power segment or refocus your efforts on customers with positive CPA. 

How to Do Customer Profitability Analysis

The cornerstone of measuring customer profitability and analyzing it is  segmenting your customers  and attributing costs and revenue according to each segment. 

The biggest misconception in CPA is that every customer is the same. Companies that look at profitability analysis as an average won’t succeed in improving customer profitability because they will go for “one-size-fits-all” solutions.

However, suppose you understand that not only customers but products also are different, each with their corresponding value. In that case, you’re on the right track to successfully analyze your Customer Profitability. 

Step 1 – Establish your communication channels .

Performing a Customer Profitability Analysis starts with looking at your communication channels and touchpoints where customers can interact with you. 

Once you get a complete view of all the channels where customers interact with your brand, you can evaluate the costs of each channel. 

For example, your costs might include:

• Marketing spending
• Social Media Ads
• Email subscriptions
• SMS campaigns. 

After you finish listing all touchpoints, you can move further to the next step – the critical element of your strategy. 

Step 2 – Set up Customer Segments .

What types of shoppers do you have, and why do they buy from you? 

Whether you break your customer base into smaller segments based on customers’ behavior or use empirical data (customer age, income, area, etc.), customers need to be divided into specific groups. 

You already know that personalization is the ace up your sleeve in eCommerce. People love to be seen and feel special, so individual attention is highly sought nowadays. If you segment Customers, it will be easier to kick off personal treatment for each customer since you already have more insights about them.

Besides customer experience , segmentation helps you get precise results with your CAP. So your future business decisions can be data-driven.  

Step 3 – Attribute Costs and Revenue .

Now that you have your segments, it’s time to  determine the revenue for each segment . 

Don’t forget to consider adjustments like discounts, fees, and service charges. Calculated profitability is only accurate when you look beyond the average and consider all revenue segment changes.

The other side of this step is  calculating each segment’s cost . When considering costs, ensure to include service & distribution costs as well as sales & marketing costs. 

While many ignore service & distribution costs, they’re crucial for accurately determining the cost attribute.

Hint  – your data might not be laid neatly in a single place or attributed to each individual customer. You might find costs grouped into different departments or your revenue spread over multiple platforms. 

Use a Customer Data Platform like Reveal to gather all your zero and first-party data in an easy, accessible way and get priceless insights at a glance. Read more about Reveal here .

Step 4 – Determine your metrics .

Now that you have all the pieces, you need to determine which metrics prove your customers’ successes with your brand. 

For example, you can look at ticket volume and determine whether particular customers are costing you more money in customer service. Connect the costs with their revenue and determine whether these customers are cost or profit centers. 

Another essential metric is in your marketing department. 

The costs per transaction show you if the money you spend on acquisition is worth it for particular customers or if you’re just bleeding your budget over low-quality customers. 

Look at all metrics your company tracks regarding product performance, customer experience, sales & marketing, and see which are related to cost/revenue.

Now, you should have a list of metrics that can be associated with the customer profitability analysis: 

• Costs to bring in a new order
• Return rate
• Shipping costs
• Customer Service costs

Step 5 – Blend them all together. 

So, you know where you spend your money, who is bringing in your revenue, and how to track profitability. 

Now it’s time to hit play, put them all in action, and run the revenue/ costs for each customer group and individual customer.

Here’s a Customer Profitability Analysis example (multiplied for each customer, of course):

With this information, you know that Customer 2 is a valuable customer that brings you more money than Customer 3, who isn’t necessarily a power customer inside your business. You stand to lose more if Customer 2 churns than if Customer 3 leaves you.

Now that you have this new knowledge, you can adjust your strategy, budgets, and product assortment to deliver better customer experiences to Customer 2. 

How to Improve Customer Profitability 

Of course, any metric can be improved to help a business grow, and Customer Profitability is one of them. 

The most obvious idea to improve customer profitability is to determine your customer rockstars, i.e., the most profitable customer group. Then focus your resources on maximizing the revenue generated by this power group. 

Kick-off customer retention strategies to keep these customers engaged and loyal and allocate more resources and budgets to meet the requirements of this segment.

Don’t mistake this idea for completely ignoring less profitable customer segments. You can also help them become more profitable by lowering the costs associated with these segments or persuading them to buy more and bring more revenue. 

Leverage your insights from your revenue/costs analysis and identify the root cause of the lack of profitability with lower segments.

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The truth is, Customer Profitability can’t be improved with a few tweaks or by pushing more people into the acquisition stage of the funnel. 

With Customer Profitability, you must adapt and evolve your organization’s mindset and attitude toward the customers.

After all, the customer experience is the current currency and what separates leaders from followers in eCommerce.

Your success depends on how you treat and engage your customer before, during, and after a purchase. 

That being the case, it’s time to align your sales, marketing, and customer experience departments with the new mindset of customer centricity – otherwise, the whole process will succumb to its knees.

CPA is an organization-wide, cross-department responsibility and can’t function on the pillar of one department alone. 

It’s useless for your marketing teams to optimize costs and deliver laser-targeted emails if the Customer Experience department doesn’t treat the power-customer right.

What happens when you don’t have the resources to kick off organizational changes?

Start small. Focus on a single product category, an individual revenue stream, or a single customer segment, then expand as you can.

Even small pilot projects can add and generate revenue in the long term. And evidently, 1% is better than 0%. Starting small is infinitely better than doing nothing at all. 

Customer Profitability Analysis (CAP) gives you a firm grasp on how much revenue you get from each customer, how much each customer costs, and where & why customers are costing you the most. 

Analyze Customer Profitability, and you’ll be armed with invaluable information.

With these insights, you can (and should) hold on to your best customers and turn less profitable relationships into improved ones.

Frequently Asked Questions about Customer Profitability Analysis

How do you analyze customer profitability.

To determine Customer Profitability you need to deduct the costs of acquiring and retaining the customer from the total revenue generated by said customer. Ideally, you would segment your customers, so the analysis is more precise: you know exactly who’s bringing your profits and who is actually costing you money rather than bringing in revenue.

What is the use of Customer Profitability Analysis?

Customer Profitability Analysis (CAP) gives you a firm grasp on how much revenue you get from each customer, how much each customer costs, and where & why customers are costing you the most. With these insights, you can retain your best customers and turn less profitable relationships into improved ones.

What are the factors of customer profitability?

Customer profitability is influenced by various factors, including revenue generated by the customer, costs associated with serving the customer, and the length of the customer relationship. Key factors affecting customer profitability include customer acquisition costs, the frequency and value of customer purchases, the cost of goods sold, marketing and advertising costs, and customer service and support costs.

Why is Customer Profitability Analysis important?

Customer Profitability Analysis is important because it allows businesses to prioritize their efforts and resources based on the profitability of different customer segments. It helps identify which customers contribute the most to the company’s bottom line and enables businesses to focus on nurturing and retaining high-value customers while optimizing resources allocated to less profitable segments.

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