What is a Profitability Analysis, and How Can it Help Your Small Business?CPA shares the benefits of profitability analysis and explains how it's done.
Profitability analysis is simply a way to determine if your small business is making money and, if so, how much. Used routinely in large companies and corporations, it is a valuable tool for business and inventory planning.
According to CPA Bryan Eaves of Sourcing Business Solutions, small business owners can use profit analysis information to build higher profits for their company.
“Profitability data allows owners to focus the business on the right products or services while minimizing time spent on areas of the company that do not generate high profits,” Eaves said.
According to Eaves, there are three important reasons to conduct profit analysis:
To prevent business failure
It is easy to stay busy with the day-to-day tasks of operating a business and lose sight of the big picture.
“Without conducting routine profit analysis, small business owners may be unaware of the exact status of their profits and losses, and this can lead to a severe crisis in the business,” Eaves said.
To determine which items are making money for you and which are not
“Performing an analysis of profitability at the product level is important so that you will know which products are making the most money and those that are losing money or not making enough,” Eaves said. Profit analysis is the best way to know which products are worth your time.
For example, if you have 15 products and only three of them actually make a profit, you might need to eliminate products.
To help simplify your business and make objective decisions
“Sometimes business owners are too close to their business, and their decisions become emotional and too difficult for them to be objective in making the difficult decisions,” Eaves said.
The data generated from profit analysis may also be helpful in determining if your marketing strategy is working or if a specific advertisement brought new sales. Banks may use it when making loan decisions.
Fundamentally, profitability analysis is based on determining profit margins.
“Part of knowing margins is knowing what your costs are to produce one item of a product,” Eaves said.
Determining your specific profit margin per item is a five-step process:
Step 1: Determine the time period you are considering and collect all the appropriate records.
Your accountant or bookkeeper will have the records you need. To calculate profits, you must first know what your sales costs are. “If you sell 5,000 of Item A per year, you must figure out how much it costs you to sell one of Item A,” Eaves said.
Step 2: Determine the money collected per item, and calculate all the direct costs associated with the sale of that item.
Direct costs include factors such as raw materials, labor, sales commissions and delivery fees. Put simply, your gross profit margin is the money you make on one item after all sales and production costs are subtracted.
Step 3: Subtract the costs per item from the associated costs.
This will give you your gross profit per item. “If you sell Item A for $300 and your costs to make one Item A is $200, then your margin is $100 per unit before overheads,” Eaves said.
Step 4: Calculate your fixed or overhead costs.
These are the costs of running your business that tend to remain constant. They include items such as retail space leasing, interest on loans, equipment rental, insurance, utilities and taxes. Once you arrive at this figure, you will divide it by the total number of items you sold during your designated time period. This will tell you the fixed cost per individual item sold.
Step 5: Deduct your overhead or fixed costs from your gross profits (determined in step 3).
This will tell you if you are actually making money and which items are most profitable. “Figure out which products make you the most margin, and capitalize on those,” Eaves said.
If the process seems too daunting, hire a professional. A bookkeeper and an accountant can help you keep the records necessary for profitability analysis and can perform the analysis for you.
Eaves recommended conducting profit analysis quarterly.
“Because cost inputs tend to change over time, keeping a sharp eye on profitability at the product level will help the business owner identify potential cost issues or an opportunity to address your own price,” Eaves said. “For example, if you sell coffee but don’t track your input costs, your coffee costs could double in six months. If you are not tracking your margins, you might not realize that you need to negotiate your costs with your supplier and also determine if you need to institute a price increase of your own.”