Trying to assess profitability by comparing a number from the profit-and-loss account (P&L) to a reference value inevitably leads to the wrong measures.
Table of contents:
Let’s start with a clarification:
Being “profitable” usually means being able to achieve a (sustainable) profit. Profit is an absolute value. It is calculated as total revenue minus total expenses and appears on a company’s P&L.
“Profitability/returns” is a relative value for assessing the economic success of your company. For this, value “A” is set in relation to reference value “B”. For the “sales return” calculation for instance, two items from the income statement are typically set in relation to one another: the operating result or EBIT in relation to sales.
I’m not happy with such formulas. When it comes to choosing which key figures you can use to assess the profitability of your company with, then I prefer to apply the following:
Ultimately, calculating the profitability based on P&L values is a vain endeavour.
The main problem is that you are showing revenues in the P&L simply because you have submitted an invoice. Absurdly enough, no account is taken of whether and when the money is actually received from this invoice.
The fact is, only money that has actually been received is relevant because only then you can use it to settle employee salaries and supplier invoices.
A key figure that can be determined relatively easily by the accounting software would be the “operating cash flow”.
In other words, the liquid funds generated by the business activity as the difference between payments in and payments out. This figure might have to be adjusted for the imputed costs.
I also eliminate the change in “accounts payable” and take this into account elsewhere.
If you are in breach of contract and leave the due supplier invoices unpaid, then you will be rewarded with an increase in operating cash flow. In my opinion, this reduces the informative value of this indicator to absurdity!
A more sensible formula for assessing the sustainable “sales” profitability of the company is this:
Profitability = adjusted operating cash flow in relation to the total payments made by your customers.
Is this indicator sufficient to fully assess the economic success of your company? Unfortunately, no.
Let’s take a company with sales of £1 million and an operating cash flow of £200k. In this case we can calculate a very respectable and comfortable sales return of 20%.
Let’s assume, however, that the company had to invest £20 million in advance to create the conditions for this. In the context of capital expenditures, the £200k now appears to be a ridiculous return on investment.
In simple terms, this company could be described as “profitable”, but not necessarily as generating an adequate return. It is therefore advisable to take into account the capital required for the business when considering profitability:
Profitability = adjusted operating cash flow in relation to your company’s operating capital.
How can you increase a company’s profitability? Now, the premise introduced at the beginning of this article, which stated you can determine profitability as a simple ratio, is taking its toll. Because this basic premise often leads to incorrect measures.
You almost inevitably direct your attention to the fastest possible increase in the value you have placed in the counter: EBIT, adjusted operating cash flow, etc, despite the complex-causality of causes and effects.
Therefore, you may try to reduce costs by laying off employees or relying on cheaper but poorer-quality suppliers. As a rule, increased costs are only achieved due to a drop in productivity and an increase in defects.
Alternatively, you may invest in risky growth strategies to increase sales. Risky because with every “wrong” customer that you acquire expensively in the course of expansion, you increase the company’s risk and jeopardise the company’s productivity and profitability.
Speaking of “risk”, this is a crucial component to consider.
In an illustrative example, let’s look at the following two suppliers. Both have sales of £1 million and an operating cash flow of £200k.
- The first supplier generates these cash flows with a single major customer who decides annually whether they want to continue the business relationship. If they don’t, the supplier is out of business.
- The second supplier generates these cash flows with thousands of small customers who will be tied to the company for many years. Even if some decide to stop their business relationship with the supplier, there are enough customers that will keep the business afloat.
The rhetorical question here is this: in which company would you prefer to invest your money in?
In dealing with this question, we have turned our attention to the future development of the company and implicitly introduced three new variables that you must take into account when assessing the profitability of the company:
- 1. Which significant risk parameters are based on the business’s purpose?
- 2. Taking these parameters into account, what range of possible returns on investment can you expect in the future?
- 3. What is the expected value in this range that you should reckon with?
How you calculate scenarios, whether deterministically (traditional) or stochastically (modern), to answer the above questions is an exciting topic in itself, but one that would go beyond the scope of this article.
“Risk” is the deviation from the expectation. Hence, the larger the range of possible returns, the riskier it will be. The following applies as well: the higher the risk, the higher the risk-related costs that your company must consider.
This question emerges for your company: is the calculated rate of return appropriate, considering the risk-related costs?
The human factor is also a significant risk factor, and one that is regularly ignored. It’s probably because there are no models and software solutions available as the standard to make the calculation easier.
In my opinion, a specific calculation is not even necessary. It is usually sufficient to simply ask: “Does this increase or decrease my business’s risk?”
Judge for yourself: do these scenarios increase or decrease your business’s risk and the sustainable profitability of your company?
- You confront your workforce with an automation campaign. Even though, based on the evidence available, you can safely assume that the implementation of the project will face their resistance.
- As the sole managing director, you also act as a sales manager and jet around the world during an 80-hour work week. The first sign of the resulting health consequences are already noticeable on you.
- A key person in a bottleneck position has had a baby, but they still have to work overtime and therefore have constant arguments at home because they don’t spend enough time with their family.
- A choleric superior treats the employees badly, the employee turnover is very high, and your company is torn apart on employer rating portals.
To draw an interim conclusion at this point:
If you are concerned about employees’ wellbeing, you are not necessarily a good person… but you are definitely a good businessperson who has the sustainable profitability of the company in mind!
Indeed, the human factor is key to your company’s sustainable profitability.
- It is not the increased turnover that leads to increased profitability …,
… but the inner attitude / mindset of your key people, who design their marketing campaigns in a customer-centred manner and do not raise false expectations.
- It is the mindset that ensures that your company clarifies customer requirements so well, that they can be processed leanly and to full customer satisfaction.
- It is the mindset that ensures that colleagues provide their face-to-face colleagues with all information on time and without being asked so that they can work productively, do their job properly and, above all, without errors.
- It is the mindset that guarantees that the company vigorously ensures that the customer pays their overdue bill.
The most important step to get there is not to think in terms of periods and indicators. Instead, it is critical to cultivate a work culture to help your employees think in terms of processes because your company employs specialists who should work in a division of labour. The output that one specialist produces is required elsewhere by another specialist as an input to continue working on the project.
The duration of many of these activities is usually not fixed, but is a range. This range is significantly influenced by the human factor – especially by unclear and conflicting mutual role expectations.
Process costing as the key to higher profitability
That said, yes, labour costs are in fact a fundamental part of any measure to sustainably increase your profitability, but not through senseless measures, such as dismissing staff in bulk or by replacing skilled workers with underqualified temporary workers. Rather, by determining the range of real working times and evaluating it in an ascribed manner.
In other words, by assigning the personnel costs to the activities according to the cause, this is the only way to find out what you would have to do to have a positive influence on the duration of the process and its range. This is the only way to find out whether a digitisation or automation campaign will deliver the added value or not.
Finally, I would like to draw your attention to another typical weak point: the treatment of the hierarchical cooperation, which is unfortunately inevitable!
In a company, there are “managers”, “leaders”, and “specialists”. I use these placeholder-terms for describing three different hierarchical roles. So, when it comes to sustainably increasing profitability, this question arises: how is the work divided between them? Who is actually doing what? These questions may seem trivial, but I assure you, it is far from it.
On the one hand, we are dealing with the concept of seniority. The junior learns from the senior. The senior is in charge and has the final say. Can the senior actually ask the junior, “Please carry my briefcase for me”? Well, do it then, if it pleases you.
But what about, for example, a young person who takes over the management as the owner’s son or daughter? Someone who, despite their years of work, could be regarded as a junior and has many senior specialists under them? Or a unit consisting of highly specialised experts?
In such cases, what is the added value of a person in a managerial position?
On the other hand, the answer is hopefully obvious because we are dealing with the concept of managerial tasks provided by “managers” and “leaders”.
The managerial tasks do not work according to the senior-junior concept, but are a high-quality service to be provided for the company and its specialists.
The problem for so many companies is that managerial positions are filled according to the senior-junior concept and managerial tasks are largely vacant.
- Wanting to assess the sustainable profitability of your company based on a P&L figure almost always leads to the wrong measures being used.
- Recognising the risk associated with the pursuit of returns and, if necessary, being able to determine the risk costs is imperative.
- The human factor is the key to sustained profitability for your company because it is the employees’ mindset that primarily ensures that processes are lean and productive.
- When it comes to sustainably increasing the profitability, it is essential to answer this question beforehand: what is our understanding of hierarchies?