Profitability Framework

Question

I just watched the "Crack The Case" tutorial on preplounge. Regarding profitability cases, they argue that "when profits go down, you either have a decline in revenue, raising costs or both" - From my point of view, this is incomplete...

In the case of discounts, costs can go up (variable/q and fixed stay the same, just "q" increases), revenues go up, and profits can still go down.

Example:

year 1: price = $4, costs = $2/q (assuming only variable costs), q ("quantity") = 4K

-> Revenues= $16K, costs= $8K, profit= $8K

year 2: price = $3 (on average a discount of 25%), costs stay the same (i.e. $2/q), q = 6K

-> Revenues= $18K, costs = $12K, profit = $6K

Conclusion: When profits go down, you can have an increase in revenue...

Please correct me if I'm wrong. Highly appreciate any comment.

Best

Answer 1

Hi,

That's correct, and that's exactly the 2nd case - increased costs

Noone said that while you have a decline in costs you can not have an increase in revenues. It's important which factor contributes to profit decrease

Best

Answer 2

You are correct that profits can go down whilst revenue increases. With an increase in revenue, costs must have increased significantly to reduce overall profitability.

In this case, costs such as fixed & variable (material/distribution) would have increased to a proportion that for each item sold, the organisation would be losing money (cost to produce > selling price). This can be improved by reducing the cost issue identified (80/20) rule, or increasing economies of scale to improve organisational profitability.