Profit decline with increase in revenue

Question

If profit has declined, but revenue has increased, would you only look at costs? I think there is still a case in which revenue growth may have declined although costs grew at the same (higher) rate as before and hence, the problem is actually slow growth of revenue because costs were growing at the same rate as before. So, we'll need to look at both, even though revenue has grown and in fact, will need to focus on growing revenue, instead of lowering costs. Is my understanding correct?

Answer 1

Hi there,

If profits declined and revenues increased you should NOT only look at costs (although you may have a hypothesis that the problem is there and prioritize that area).

The problem could well be on revenues, mainly for two possible reasons:

Multiple revenue streams. Revenues of A (low margin) went up, bringing overall revenues up. But Revenues of B (high margin) declined, leading to overall lower profits. The problem thus is the decline in revenues of B
Revenues went up due to a decrease in price. This led to higher revenues, but lower margins thus lower profits. The problem thus is the decrease in price

Hope this helps,

Francesco

Answer 2

Hi, I confirm it is not only a matter of total revenue and total cost, but the mix is important. About revenues, you should understand the major revenue streams and how they are changing (e.g. if I'm selling my least profitable product more than before, my profit is in decline even if I'm growing in revenue and market share)

Best,
Antonello

Answer 3

This sounds like a mix shift. If the growth in revenue is driven by a product with lower margins, the revenue goes up, but total costs grow faster. Key is to look at breakdown of revenue and costs by product in the portfolio.

If that doesn't explain the profit decline, you might also look at a number of other things

Pricing & discounting (did the client buy the increase in market share with lower prices or higher discounts)
Cost of sales (how many sales people are driving the revenue increase, if you hire an army of sales people your revenue will go up, but also the costs)
Increased administrative costs (unlikely because boring for an interview case ;)

Answer 4

Hi there,

You're partially there.

Really, you need to look at Total Contribution Margin. This is a more sophisticated way of breaking out Profits by spliting it by Fixed Costs and Contribution Margins (i.e. # units and unit contribution margin...with unit contribution margin equalling price minus associated variable costs).

This will help you understand if the product mix has changed, or if fixed costs were the problem, or if variable costs were the problem.

Answer 5

Draw out the classic profitability tree and work through each branch carefully & systematically. You should have the following hypothesis:

Increase sales by reducing price (discounting) at smaller or low margin
Increased expenses (e.g one time investment or higher salaries etc) to meet the increase in sales
Increasing costs (fixed and/or variable) to increase production for higher sales