By Manyara Chigunduru, Managing Partner of Marianhill Chartered Accountants
It is my pleasure to embark on this profitability series which will touch on so many aspects of an organisation’s growth and sustainability. In these series, we shall deal with all issues around company profitability, from merely having an appreciation of what it means to understanding how a failing company can return to profitability.
For any company to continue as a going concern it has to be profitable in its ventures. All entrepreneurs should understand that they are in business to be profitable i.e. to make money. The sustainability of such profits lies in the ability of the entrepreneur/leader/business owner to determine a financial strategy that speaks to the vision and mission of the business, which in turn determines the profitability of the entity. It is important to understand the key factors which determine profitability so that as management or business owners we are in a position to then craft strategies that enhance profits in our businesses.
The Anatomy of Profit
Profitability of a company is determined by the resultant positive surplus, after taking into account all income earned and expenses paid, for a specific accounting period or a project. The reverse becomes a loss when expenses are more than income received, resulting in a deficit. If we borrow definitions from the accounting framework, income is defined as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets. On the other hand, expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets. With these definitions, we can then move forward to discuss some of the factors that determine an entity’s profitability.
Factors that Determine Profitability of an Entity
The determinants of profitability are quite broad and are dependent on different situations the business finds itself in. Today an entity can be very profitable, but faced with different factors, the same entity can run into losses. As business owners, we need to be cognisant of some of these factors every time we think ‘PROFITABILITY.’
Main Objective of the Entity
Different businesses have different objectives and goals. The activities that management embark on in a for-profit entity are completely different from a not-for-profit organisation. Their financial strategies are also completely different as these are driven by different goals. Therefore, it is important to know the objectives of each business as these will determine the type of action that management will take to sustain the entity.
Management’s Role
Some managers believe that companies owe them in terms of benefits, thus they make every effort to strip an organisation of its assets as a way of rewarding themselves. As leaders, we act in a stewardship role in these businesses and our actions should reflect this role. As stewards, we protect and grow that which has been left in our care. As a result, we should know our roles in entities that we are part of.
Overhead costs
These are costs that are not directly related to the production of goods or services. Mostly these costs include administrative costs such as head office costs (salaries and benefits) which if not properly controlled may lead to an entity operating at a loss. Thus, we need to watch out for unnecessary overheads.
Product Pricing
The way we price our products or services has a direct impact on profitability. Charging too high a price may scare away customers unless for some reason one is offering a unique and specialised product which justifies the high price. On the other hand, charging too low a price may still scare away customers, with suspicions of poor quality products or services arising. An optimal price should be charged which reflects the value that your product or service is giving to your customers.
Demand of Product
Whatever products or services we offer, it is important to determine if there is demand for that product. This can only be done through research in the chosen market to see if customers want that product or not. Without demand, a product or service will not provide the revenue that is desired. Thus, it is important to determine the demand of our products or service offerings.
Level of Competition
The level of competition in the chosen market can increase or decrease profitability depending on whether competition is minimal or excessive, especially from substitute products. As business owners, we need to understand the direction that our competition is taking so that we price our products accordingly.
State of the Economy
Depending on the type of product or service an entity is offering, the state of the economy has a direct impact on profitability. If the economy is not doing well, generally profits tend to plunge as consumers’ spending will be constrained. A growing economy has good prospects for growth given the increased demand by consumers.
Advertising / Brand Awareness
The frequency at which we advertise or engage in different brand awareness activities has a bearing on the number of customers who may want our products or service offerings. Advertising can be done through media, sponsorships, or by word of mouth especially by our current customers. We should strive to satisfy our current customers with our products or service offerings for they ‘make or break’ our businesses.
Internal Controls
These are processes that are put in place by an entity to ensure that organisational objectives, in operational effectiveness and efficiency, reliable financial reporting, and compliance with laws, regulations and policies, are met. The level of implementation of internal controls determines the extent to which our businesses are protected from fraudulent activities which have a direct impact on the company’s profitability. Thus, let’s plug these control weaknesses to enhance profitability of our entities.
Thus, in conclusion, it is important to interrogate the direction that the profitability of your business is taking and understand why your profits are either going up or plunging. In our next article, we explore ways of measuring profitability using financial information available to us as business owners.
Manyara Chigunduru is the Founder and Managing Partner of Marianhill Capital (Pvt) Ltd & Marianhill Chartered Accountants in Zimbabwe, offering financial advisory services, corporate finance, entrepreneurship development, and project finance to companies and individuals. Manyara, who is a Chartered Accountant (Zimbabwe) and a Registered Public Auditor has over 15 years’ experience in financial management, accounting, auditing and taxation. For views and comments send emails to info@marianhillca.com or visit www.marianhillca.com
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