How to start a profitability case with the right logic?

Question

Good morning,

After I isolated that the cause of a profit decline must be internal, I always use the logic that either revenues must have gone down, cost up or both. I then examine first revenues and costs. If I see that revenues are up (or costs down), I know that this branch is not responsible for the profit decline and can exclude it. Am I right that here the logic is that absolute profits decrease if the absolute change in costs is bigger than the absolute change in revenues?

How do I get a similar framework when I tackle a case where profit margins have decreased and I know its an internal problem? Is it that the percentage increase in cost must be bigger than the percentage increase in revenues? Generally in such a situation I can't say anything if absolute profits have decreased as well?

Answer 1

Hi,

It doesn't matter whether the revenue decrease is bigger than the costs increase or vice versa. Both the revenue decrease and the costs increase are the profit decrease drivers and you have to examine both.

Also in many cases, you will not be able to understand whether the problem is external / internal on the profit step since the interviewer simply will not have this information. You will understand it later on the revenue / cost side.

I would recommend the following approach:

1) Ask clarifying questions:

- Clarify the business model (i.e. how the business works and what are the revenue streams / core products or business lines). Why do you need to know the revenue streams? Because it's one of the most critical pieces in understanding the business model. An example is Oil&Gas with up-, mid- and down- streams that are completely different businesses.

- Clarify the objective both in money terms and timeline (e.g. Our objective is to increase profits by 5M in 5 years). When you have a to select from several options in a case - clarify the selection criteria

- Clarify other possible limitations if you feel that it's necessary

2) You make a classic profitability structure adapting it to the case. Sometimes cases are not that easy as just declining profits. For example, if the profits are lower than planned, it is either because we have problems with profits or we have problems with planning. Try to be MECE here.

3) While you do your structure you split the revenues first by the revenue streams (if you have multiple streams) and then into either:

Price and quantity for the production companies. I also recommend to add proactively the 3rd boxn - the "Mix". Thus you show your business sense and demonstrate that you know the most common case traps. Pls note that the "mix" can be anything - geography, customer, product, etc.
The number of customers and the average check for retail stores, restaurants, ets. You can further split the customers into traffic and conversion (if relevant, e.g. for a fashion store) and the avg check into the products and prices

3) Costs I would split into Fixed and Variable. VCs you can split futher into costs per unit and units sold

4) I would start the case by checking whether its increasing revenues, declining costs, or both - so that you could eliminate the part that is irrelevant. Then you dig deeper into the parts of your structure

5) You may split into internal / external causes on the price / qty level

Best!