If you’re a business leader who sits more on the financial side, then you play a vital role in helping your organization increase their profitability. But, where do you start making changes? One powerful tool in your arsenal is the profitability tree. This tool helps you create a visual in order comprehensively analyzes your company’s economic performance, by looking at the factors that impact costs and revenue.
In this article, we will delve deeper into the profitability tree, explore its significance across different industries, and teach you how to create one. Finally, we’ll discuss how you can use it to determine areas of improvement for your organization.
What is the Profitability Tree?
The profitability tree is a strategic framework that visually represents the cause-and-effect relationships among various factors affecting a company’s profitability. This enables businesses to understand how different aspects of their operations impact their overall financial performance. By using this approach, companies can identify key drivers, focus their efforts on areas with the highest potential for improvement, and make data-driven decisions to optimize profitability.
The profitability tree begins with profit at the top of the tree and then splits between costs and revenue. For example, let’s look at the top of a profitability tree:
It’s possible to create your profitability tree on a monthly, quarterly, or yearly basis — whichever makes sense for you. Let’s say you do it on a quarterly basis. Take a look at your last quarter, and write at the top what your total profits were. Then, beneath costs, write your costs or expenses for that quarter, and beneath revenue, write your total revenue for the same quarter. Remember, revenue refers to the total amount of money generated from sales of goods or services during a specific period, while profits represent the amount that remains after deducting all costs and expenses from the total revenue.
The image above demonstrates the beginning of the initial split in the profitability tree, demonstrating the fundamental division between what your company spends and what it earns.
Let’s explore what comes next.
What Does a Profitability Tree Look Like?
Now that you know how a profitability tree starts, what does it look like as you continue breaking down the tree? What is it made up of going forward? How does the format of the profitability tree differ for each industry the business using it, and how can you customize it further to really understand where to make your profitability improvements?
Below, we’ll answer these questions and more. This phase is where customization comes to life, tailored to your business specifics, offerings, and objectives.
Part I: Revenue in the Profitability Tree
Generally, on a profitability tree, “Revenue” will be followed by “Number of Customers” and “Revenue per Customer” or “Number of Subscribers ” and “Revenue per Subscriber”. Of course, choose attributes based on whatever makes sense for you in terms of your business and getting a visual of your goals and, ultimately, how you’ll be using the profitability tree in order to improve your profitability index over time.
Let’s give a more detailed example:
- Revenue: $50,000 (Total income from subscriptions)
- Number of subscribers: 1,000 (Total active users)
- Revenue per subscriber: $50 (Average revenue from each subscriber)
In this scenario, the platform generates revenue from subscriptions. It has 1,000 active subscribers, and each subscriber contributes an average of $50. This breakdown offers insights into the business’s financial health and helps refine strategies to enhance profitability.
This approach can be applied across industries, customizing terms to match each business’s specifics. For instance, in an e-commerce setup, it could involve “Sales Revenue,” “Number of Orders,” and “Average Order Value.” This tailored approach aids in understanding and optimizing revenue sources for sustainable growth.
If you’re having trouble getting started, a business consultant can help determine what should go in each box.
Part II: Costs in the Profitability Tree
Next up in the profitability tree is the “Costs”. Here, the branches break down into “fixed costs” and “variable costs”, which despite the fact they may seem obvious to business leaders, actually require some thought. It’s actually in this phase of filling out the profitability tree that C-level leaders may be surprised at what they see in front of them.
Whethef you’re planning on starting a business or you’re working on restructuring your own, here’s a refresher:
- Fixed Costs: Fixed costs are expenses that remain constant regardless of changes in production levels or sales. These costs do not fluctuate with variations in business activity. Examples of fixed costs include rent, salaries of permanent staff, insurance premiums, and lease payments.
- Variable Costs: These are expenses that change proportionally with the level of production or sales. As business activity increases, variable costs also increase, and as business activity decreases, these costs decrease. Common examples of variable costs include raw materials, direct labor costs, and sales commissions, as they are directly linked to the quantity of products or services produced.
In the context of a profitability tree, fixed costs and variable costs can be adapted to virtually any industry. Let’s look at an example of a restaurant chain for a clear understanding of how this would work when mapping out your tree.
- Rent and utilities in each location: The rent and utility expenses for each restaurant location remain relatively stable over time, regardless of the number of customers served or the level of business activity. These costs constitute fixed expenses that the restaurant chain must incur to maintain its physical presence.
- Food and beverage costs: The cost of ingredients for preparing dishes and beverages directly relates to the number of orders and the menu items sold. As customer demand fluctuates, these costs also change, making food and beverage costs a variable expense.
- Labor costs: Labor costs, including salaries and wages for chefs, servers, and support staff, are directly tied to the volume of customers and the level of service required. On busy days, more staff members are needed, leading to higher labor costs, while slower days result in lower labor costs.
- Marketing and advertising expenses: Marketing and advertising costs can vary based on promotional campaigns, events, and seasonal fluctuations. For instance, costs for special promotions and events would increase during those specific periods, making them variable expenses.
By separating out these costs, the restaurant chain can visually understand the dynamics of their expenses. The ideas is that by seeing it all laid out on the profitability tree, it will enable their C-level leaders to make informed decisions about pricing strategies, staffing levels, and promotional initiatives to optimize profitability.
Part III: Cost and Revenue Drivers in the Profitability Tree
Now, let’s take this all a step further to understand the factors influencing the costs and revenues you had in the last step. Here, you’ll uncover essential elements directly tied to generating income and managing expenses, known as “drivers”. These factors serve as focal points for strategic improvements that can directly impact profitability. By thoroughly examining these elements — again, tailored to your company’s specific operations — we gain insights into various aspects of costs and revenues, paving the way for enhanced profitability.
Below are examples of the different categories of cost drivers. This can help you have a better idea of how your fixed and variable costs are influenced by, in order to organize this next stage of your profitability tree and eventually, create business goals for increased profitability:
- Direct costs: Think of expenses intricately tied to the production of goods or services. Analyzing and optimizing these costs can have a significant effect on the final profit margin.
- Indirect costs: Focus on expenditures that support business operations but aren’t directly linked to production. Later, knowing how to streamline these costs can increase overall operational efficiency.
- Labor costs: Paying attention to how to manage labor costs efficiently contributes to improved financial outcomes.
- Overhead costs: Take a look at expenses like rent, utilities, and administrative costs. If you can find ways to unnecessary overhead expenses directly contributes to enhanced profitability.
And, here, the same concept but for revenue drivers:
- Product/service mix: This involves evaluating the contribution of various products or services to overall revenue, which will guide the focus toward high-performing offerings.
- Customer segments: Here, you’ll identify profitable customer segments, which aids in resource allocation and tailoring effective marketing strategies.
- Geographic markets: Are you able to pinpoint lucrative geographic regions now? This will help you to determine areas with the highest revenue potential.
- Sales channels: Can you assess the efficiency of different sales channels — such as online platforms or physical stores — which can assist in optimizing revenue streams?
Let’s use an example of how these drivers look with a start-up SaaS company:
- Direct costs: The startup identifies that the development and maintenance of the software application itself, including coding, testing, and bug fixes, are the primary direct costs.
- Indirect costs: After closer analysis, the company realizes that cloud hosting fees, licensing for third-party tools, and office space rental contribute significantly to their indirect costs.
- Labor costs: Employee salaries — including software developers, customer support staff, and sales representatives — comprise a substantial portion of the overall costs.
- Overhead costs: The company discovers that costs related to marketing campaigns, utilities, and administrative expenses also play a role in their overall financial health.
- Product/service mix: A thorough assessment reveals that certain premium features within the project management tool generate higher revenue due to their value proposition for larger enterprises.
- Customer segments: The startup identifies that its most loyal and high-spending customers are tech companies seeking comprehensive project management solutions.
- Geographic markets: Through data analysis, it’s clear that their tool gains substantial traction in markets with a strong emphasis on remote work and digital collaboration.
- Sales channels: The startup realizes that partnerships with tech blogs and YouTube influencers significantly contribute to their lead generation and revenue generation efforts.
By dissecting the “Cost Drivers” and “Revenue Drivers,” businesses gain a nuanced perspective of the factors that influence profitability. Addressing these drivers through strategic initiatives can result in improved financial performance.
But, we’re not done, yet!
Part IV: Profitability Improvement Ideas in the Profitability Tree
Hopefully by now, the profitability tree in front of you has given you a very detailed visualization of your current financial operations. Now, the final step is to understand how based on the information above, you can optimize costs and enhance your revenue. Again, this is a general suggestion of how to format your profitability tree, but this step may look slightly different depending on your industry and what you’re looking to achieve going forward.
Let’s use an example of a fashion retailer:
Let’s say you’re a CFO who runs a fashion retailer. You’ve created your profitability tree and now you understand where you may need to make some specific improvements. At this point, you may talk to product designers, project managers, sales and marketing — as well as your partners — to thoughtfully brainstorm data-driven ideas that correspond with the results you’re finding in your profitability tree. Perhaps some ideas that come to mind are:
- Introduction of a loyalty program: Consider launching a loyalty program designed to encourage repeat purchases among existing customers, thereby boosting revenue streams.
- Exploring influencer collaborations: Think about partnering with influencers to expand brand visibility, potentially leading to increased customer engagement and higher sales.
- Fine-tuning inventory management: Consider implementing advanced inventory management techniques to reduce carrying costs, minimize stockouts, and improve overall operational efficiency.
This last part of the profitability tree represents the actionable steps that hold the potential to enhance the financial well-being of the business overall. But, remember that it’s just a tool. Your role remains pivotal in nurturing these strategies and driving their successful implementation, ushering in tangible improvements in profitability. And, working with a business consultant could be the power team you need to sow the seeds of your profitability tree.
Profitability Trees & Profitability Index: How They’re Connected
What is Profitability Index?
The profitability index — a pivotal financial metrics — provides a quantitative measure to evaluate the attractiveness of potential investment projects. The fashion retailer with ideas to more effectively manage costs and revenue? Well, those ideas aren’t really worth adapting without looking at their profitability index. That’s because this formula helps assess the ratio between the present value of expected future cash flows and the initial investment required.
Let’s explain this a little more.
The Interplay Between Profitability Trees and Profitability Index
The relationship between profitability trees and the profitability index is important to understand as a C-level leader:
- Profitability trees: Imagine the profitability tree as a comprehensive map dissecting a company’s financial landscape. It disentangles the multifaceted factors that impact profitability, revealing connections and interdependencies. This visual framework that you now know how to create, aids in identifying areas for improvement, while guiding goal-setting and fostering strategic decisions.
- Profitability index: In contrast, the profitability index sharpens the focus on individual investment projects. It serves as a precise numerical tool to assess a venture’s potential return relative to its initial cost. This index empowers businesses to prioritize projects aligned with overarching financial goals.
Ultimately, while the profitability tree paints the landscape, the profitability Index pinpoints the most promising paths. Together, they form a unified strategy, guiding businesses toward both the panoramic view and the granular details of financial success which the future of the business counts on.
3 Tips to Help You Create Your Profitability Tree
Though you now have a template for creating your profitability tree, don’t worry if you’re feeling a little stuck. Here are some tips to help you work through it:
Tip 1: Work with what you have
Begin by delineating the fundamental financial metrics that hold sway in your industry. Metrics like revenue, COGS, gross margin, operating expenses, net profit margin, and ROI form the bedrock of your analysis. This initial groundwork primes your understanding for the more intricate phases ahead. If you have data on this already, use that to to start plugging in the tables on your profitability tree.
Tip 2: Start small
Next, segment your revenue sources and cost categories specific to your business model. Start with one of each if that helps. This step maps out the basic revenue streams and cost components that fuel your financial ecosystem, but you’re laying them out at a pace that’s not too overwheleming.
Tip 3: Utilize digital tools
There are so many digital tools out there that can help you understand all the financial data you need to look at in a manner of minutes. The problem is, many companies don’t know which tools are best. But, just a little research can go a long way. And, these tools can help you also understand the profitability index of new ideas.
How Business Consultants Help With Profitability Trees (& More)
Creating a profitability tree is just one way to understand your business more clearly. But, doing this with the support of a business coach can help you ensure you’re getting the most out of this tool. Here are just some of the ways business consultants can help optimize your business’s profitability:
- Data analysis expertise: We uilize advanced data analysis skills to identify trends, uncover hidden insights, and make data-driven recommendations.
- Industry-specific knowledge: We leverage our deep understanding of various industries to tailor the profitability tree approach to your specific challenges and opportunities.
- Strategic recommendations: We develop tailored strategies for revenue optimization, cost reduction, and overall profitability improvement.
- Change management support: We provide guidance and support to navigate through changes seamlessly and ensure the successful execution of new strategies.
- Continuous monitoring and evaluation: We continually monitor financial performance, assess the profitability potential of new ideas, assess the effectiveness of implemented strategies, and make adjustments as needed for sustained success.
By partnering with a business consultant in order to employ profitability tree approach, you can uncover the drivers of profitability and identify growth opportunities. You can also chart a course toward sustained financial success for your small business.
The Bottom Line
The profitability tree approach is a systematic and data-driven method for improving financial management, and a simple way to visually understand more about your organization. However, that’s just the start. Whether you need assistance putting a profitability tree together that’s unique to your business — or you want to know what to do with that information you uncover — consider reaching out to a business consultant that’s ready to take on the task. Book a call today!