Profitability Analysis

Profitability analysis seeks to understand a company’s ability to generate profit. When companies report on sales and profitability data, analysts can then drill into that data by analyzing drivers like customer, country, product, number of units, price etc., in order to identify which drivers are yielding profits and which drivers are leaking them.

Common drivers are:

• business segment
• product/service type
• sales channel
• geographical area
• customer type 
• individual customer
• stage in the production process

Each driver is analyzed to determine segments that are most profitable and identify those which aren’t. For example: the most profitable customers vs. the least profitable customers. Thorough profitability analysis can provoke positive change within organizations, leading to action based on key insights, like fast responses to changing customer needs. It functions to maximize the effectiveness of the product mix and remedy areas of decreasing profit margins.

Activity-based costing (ABC) is a costing methodology used to more accurately allocate overhead/indirect costs to the items and activities that use it. The ABC costing method does this by assigning costs to products, services and projects based on the resources activities consumed and the subsequent activities that go into them.

ABC is an effective way for businesses to understand the complex relationship between cost and profitability as a result of products, customers, production and processes. By assigning indirect costs to these activities, ABC is used to reduce superfluous overhead, unprofitable products, identify ineffective processes and lower prices. 

Often, ABC is used by the manufacturing industry because of the emphasis on production, the complexity of its activities, and their associated costs.