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Profitability Framework

Logic
Recent activity on Aug 15, 2018
2 Answers
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Anonymous A asked on Aug 15, 2018

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.

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Vlad
Expert
updated an answer on Aug 15, 2018
McKinsey / Accenture Alum / Got all BIG3 offers / Harvard Business School

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

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Cédric on Aug 15, 2018

so this means the factor who contributes to profit decrease here is the rising costs - which rise stronger in % terms than the revenues, thats why we have less profits?

Anonymous replied on Aug 15, 2018

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.

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Cédric on Aug 17, 2018

You are right, but in the example above this is not the case. How would u answer such a situation in a real case? We realize that costs have increased, whereas revenue havent decreased. Hence, we drill down the costs branch to figure out the root cause of the problem. But in this example, we see that costs/unit have not increased (see above they are still $2/q, assuming there are no fixed costs). Furthermore, the selling price (now $3) > cost price (still $2/q). Would you just focus on the revenue branch and figure out that due to lower price the costs have increased stronger than sales?

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Vlad gave the best answer

Vlad

McKinsey / Accenture Alum / Got all BIG3 offers / Harvard Business School
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