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Why not divide profitability in to profit / product and fixed costs?

Carl asked on Jul 12, 2019

Hi,

Most time I get tips on profitability cases people tell me to go with revenues and costs as the two main branches, which makes perfect sence as these two really are the main drivers of profitability. But then under revenues they usually go with price * volume and costs divided into fixed and variable.

Wouldn't it make more sence to divide profits into profit/product (or customer) * number of products - Fixed costs, since that is the formula. Then divide profit / product into price and variable costs per product if you find out that this is the problem. Is there any reason why this would be worse or less effective/structured than the regular revenues and cost framework?

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Leif
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replied on Jul 12, 2019
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Hi,

I assume that when you say "divide profits into profit per product * number of products", you really meant "divide profits into variable margin per product * number of products"? Otherwise your formula is wrong, since profit per product already has fixed cost taken out.

It is one way to break down profitability for sure. It is more often used later in a case for analysis, but rarely used upfront to set up your initial framework. Sure you can set up your framework this way, but there are several risks:

  • It is not a common practice. Interviewer may not be expecting it. So you run the risk of confusing your interviewer, which is not good.
  • It is obviously more complicated than a simple "revenue - cost", so you may have a bit extra explanation you need to do, which takes time. And time is precious.
  • Most importantly, it is not strictly MECE. The "variable margin per product" part has a cost component built in it, yet cost shows up again in the "fixed cost" part.

There might be situations where setting up your framework this way better fits a case, but I personally have not seen any case like this before.

Thank you so much for your answer Leif, it is excactly what I was seeking and I agree with your analysis. Basically I got stuck at a particular case which was "Should an opera open a night club as well?". In the profits for me there are a few things to consider: profits from new customers, profits from current visitors to the opera that also visits the night club, cannibalization in terms of visitors that will now skip the opera but go to the night club and the people that will skip both (perhaps they think that this disturbs the brand of the opera or something). Question then is where does the fixed cost go and how excactly would I calculate it.. Been stuck at it for a couple of hours — Carl on Jul 12, 2019 (edited)

Well, do you really need to calculate how much exactly the fixed cost is, and how much of it goes into each of the 3 pieces? What you really care about is the change in fixed cost right? In terms of where it should go, it can just be a separate standalone item in your issue tree. Let me know if I misunderstood your question. — Leif on Jul 12, 2019

So I want to calculate the profits from this investment basically. Here I am thinking that we need to take into account the "loss of profits" from cannibalization. So what I am wondering is what the full calculation of such decision would look like. Let us say that the fixed costs with starting the night club is 100000USD which accounts to the electricity you need. The entrance price is 100USD and the average spend per customer per night is 50 USD and it is open 200 days per year. They have seen that 30 people will go each night, however, 5 of these where previously customers to their opera business and will now skip that. How would you calculate the profits of this decision and more importantly how would you explain your logic in a structured way? — Carl on Jul 12, 2019 (edited)

Well if you break down profit, it would be revenue and cost right? So calculate "loss of revenue" from cannibalization. Then calculate "change of cost" from cannibalization. Then add them up. — Leif on Jul 12, 2019

So profits = revenues - costs = Revenues from night club - Loss of revenues from Opera through cannibalization - (Cost for night club + change of cost for cannibalization) ? Should be the same as Profits = Profits from night club - Profits loss from cannibalization. Not sure if it is MECE though since when you calculate the Total profits for the night club you also conclude the visitors that contribute to the cannibalization — Carl on Jul 12, 2019

Vlad replied on Jul 12, 2019
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Hi,

You got it wrong. There is no standard framework to split the revenues into volume and price. You can split the revenues in the following ways:

  • Price * Volume * Mix for the companies selling 1-3 products
  • # of customers * Av. check if you have 3+ products. Think of retail with thousands of SKUs or restaurant
  • Market * Market share - can be useful in specific cases

You should always clarify at the beginning of the case how many products you have. In case of multiple products (<3) you can split revenues by product or even profit by product depending on the context, objective and the product.

Best!

I agree with you. The thing i am concerned about is the first level, which is usually revenues and costs. Why is the first level not Profit / product (or per customer if you have +3 products), number of products (or customers) and fixed costs? Then under profit/product you can either divide into products if you have less than three or go direct to cost/product and price? This should be MECE as the fixed costs is not per product right? — Carl on Jul 12, 2019

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