Profitability Modeling: The Financial Strategy Tool Your Business Needs to Ensure Success
April 15, 2022 •Jordan Lyle
A business without a profit is just a professional hobby. And while we’re all for doing what you love, I think we can agree that it’s always more fun to make money while you do it. Profitability Modeling gives you the ability to strategically look at all the unique elements, big and small, that make your company viable and profitable. From there, you can feel confident taking the wheel as you steer your organization through a variety of obstacles and market changes including revenue, expenses, interest charges, perpetually changing market trends, etc.
Four Techniques to Include in Your Profitability Model
Your business and the way it operates is unique. It’s important to develop a profitability model that accounts for each of those unique elements such as production, sales generation, delivery and other market factors, and lends awareness to the small but significant market variables that can end your fiscal year in the black or in the red. Below are four techniques you should ensure you’re using when crafting your custom profitability model. A model that doesn’t include each of these techniques is inherently flawed and lacking a necessary and strategic component.
Historical Profitability Technique- There is always something to be learned from our past and using the historical profitability technique proves to be no different. This technique help make accurate financial forecasts for companies in a stable market with slow and predictable financial changes. You can track related variables like revenue and expenditures based on prior experience. Extend your past rates of change into the future and see where the numbers take you. However, historically speaking, stable markets are about as common as winning the lottery. As financial experts, we don’t advise gambling with your business, so we’ll need to add some other techniques to layer on to this baseline approach.
Dynamic Profitability Technique- Finances constantly changing? For most of us, the answer is yes. With this technique, you can calculate interest charges or increasing material costs and add them to expenditures while projecting increasing revenue due to higher sales. There are a lot of components for you to consider when using this technique, and how daring you will be is determined by your goals and your aversion to risk. Calculations based on these considerations will allow you to estimate profits and forecast company profitability. Doesn’t clear skies with a 90% chance for a 50% YOY growth rate sound nice? Our thoughts exactly.
Trend-Focused Profitability Technique- Okay, so now we’ve got a clear look at your business, but we need to look at external factors too. In the business world, if you’re behind the times, your competitors are already doing things better and smarter. As a result, you’re losing revenue and constantly playing catch up. By using the trend-focused profitability technique, you can monitor the competitive landscape and examine trend-related market factors. How much will an observable trend affect your forecast? How hard will the rise or fall of a competitor hit your bottom line? What steps can you take to mitigate the effect or capitalize on the situation? A trend-focused profitability technique incorporates these types of contingencies to stop you from chasing your competition and become the leader in your industry’s race. We’re rooting for you already!
Analytical Profitability Technique- Time to fine tune your model based off the information you’ve learned from the other three techniques and use them to your business’ advantage. This technique takes a deep dive into the industry, the market and a range of other variables to determine how expenses will affect your profitability forecasts. Basically, this technique avoids you walking into a new industry sight unseen with your fingers crossed just hoping for the best. While we love the confidence in that approach, smart business is strategic business.
Now What? Your Next Steps After Developing a Strong Profitability Model
Once you’ve worked through each of these techniques and built a strong profitability model, it’s time to get to work making calculations, monitoring results and making necessary operational changes, as needed. Though creating and managing your profitability model will take some time and attention, the long-term benefits will ensure your company’s long-term success.
At SMART, our financial experts have helped a wide-variety of companies with big-picture financial solutions including creating and managing their profitability models. We’re not just accountants, we’re financial partners who think like entrepreneurs and act like a trusted friend. Give us a call to discuss how we can help your business be at its best.