PROFIT MANAGEMENT

Every business must focus continually on managing profit and loss to remain solvent. Profit is
the money a company keeps after paying all of its expenses. A loss results from expenses
exceeding the amount of sales a company makes in a specific accounting period. Companies
must manage their income statements, also known as profit and loss statements, to keep earnings
positive and expenses under control and in line with revenue.
Initial Financial Assessment
Managing profit and loss begins with an assessment of the company's current financial position.
Management must review the current profit and loss statement and compare it to the company's
last two or three years of historical data. An accountant or analyst can use this information to
establish a set of performance benchmarks for the company's average revenue and expense
levels.
Preparing Analytical Tools
Management should have an accountant or analyst prepare analytical tools such as a commonsize income statement. This income statement shows every expense as a percentage of sales,
allowing management to isolate costs that could contribute to decreasing profits. The company
can perform this analysis for, preferably, three years of historical data. An analyst compares the
three years to each other by reading across horizontally. Expenses as a percent of revenue are
compared for each year to reveal trends that show expenses rising or lowering as a percent of
sales over time. Some costs, such as the cost of goods sold, will naturally rise with sales
increases because they represent the raw goods used to make products to sell. Building rent,
administrative costs and some utility bills should remain the same, regardless of increases in
sales.
Explaining Expense Growth
An analyst should perform additional work to investigate and explain expenses that show growth
over time as a percent of sales. This exercise can reveal valuable information about the
company's use of resources and managerial cost oversight. External factors such as the economy
and rising prices also can explain cost increases.
Sales Review
An analyst should next review the company's sales. Depending on various events and conditions,
even when internal expenses have been well-managed and cut as low as possible, the company
may still suffer a loss if its sales drop below its expenses in any given accounting period. In this
case, the company must make important decisions such as discontinuing certain unprofitable
product or service lines, selling off assets to free up capital and discontinuing investments in any
projects that do not generate revenue.

FACTORS THAT DETERMINE PROFIT

The factors that determine profit in an organization include:
1. The degree of competition a firm faces is important. If a firm has monopoly power then it has
little competition, therefore demand will be more inelastic. This enables the firm to increase
profits by increasing the price.
2. If the market is very competitive then profit will be low. This is because consumers would
only buy from the cheapest firms. Also important is the idea of contestability. Market
contestability is how easy it is for new firms to enter the market. If entry is easy then firms will
always face threat of competition. This will reduce profits.
3. The strength of demand is very important. For example demand will be high if the product is
fashionable, e.g. mobile phone companies have been very profitable.
4. The State of the economy. If there is economic growth then there will be increased demand for
most products especially luxury products with a high YED..
5. A successful advertising campaign can increase demand and make the product more inelastic,
however the increased revenue will need to cover the costs of the advertising. Sometimes the
best methods are word of mouth.
6. Substitutes, if there are many substitutes or substitutes are expensive then demand for the
product will be higher. Similarly complementary goods will be important for the profits of a
company.
7. The other aspect of profitability is the degree of costs. An increase in costs will decrease
profits, this could include labour costs, raw material costs and cost of rent. For example a
devaluation of the exchange rate would increase cost of imports therefore companies who
imported raw materials would face an increase in costs. Alternatively if the firm is able to
increase productivity by improving technology then profits should increase. If a firm imports raw
materials the exchange rate will be important. An depreciation making imports more expensive.
However depreciation of the exchange rate is good for exporters who will become more
competitive.
8. A firm with high fixed costs will need to produce a lot to benefit from economies of scale and
produce on the minimum efficient scale, otherwise average costs will be too high.

9. If a firm is not dynamically efficient then over time costs will increase. For example state
monopolies often had little incentive to cut costs, e.g. get rid of surplus labour. Therefore before
privatisation they made little profit, however with the workings of the market they became more
efficient.
10. If the firm can price discriminate it will be more efficient. This involves charging different
prices for the same good, so the firm can charge higher prices to those with inelastic demand.
This is important for airline firms.

Powell, Thomas C. (1996). How Much Does Industry Matter? An Alternative Empirical Test,
Strategic Management Journal 17(4), pp. 323-334.

Roquebert, Jaime A., Robert L. Phillips, Peter A. Westfall (1996). Markets vs. Management:
What Drives Profitability?, Strategic Management Journal 17(8), pp. 653-664.

Thomadikis, S.B. (1977), A Value-Based Test of Profitability and Market Structure, Review of
Economics and Statistics 59, pp. 179-185.