An Introduction To Profitability Frameworks
PROFITABILITY
This is the most common case type. Essentially, your goal is to understand what is driving decreasing profits, and whether that is a function of decreasing revenues or increasing costs.
Once you determine the key driver, you can then use the data in the case to suggest strategies/recommendations for reversing the client’s situation.
Some examples of ‘Profitability’ archetype cases include:
Our client is a low-cost airline based in Singapore, serving 24 destinations in the Southeast Asian market. Its profitability was strong until 2010, and has since seen a declining trend and is now just barely profitable. The CEO would like you to determine what is causing their decline, and suggest a strategy to reverse this trend.
The client is a market-leading, niche phone screen manufacturer based in Ohio. Profitability has remained steady, but the CEO has noticed from reading industry annual reports that two publicly-listed competing phone screen manufacturers have meaningfully higher profit margins and have also been increasing their top line (re: revenue). The CEO would like to understand what is driving such differences.
When posed such questions, you may already be presented with valuable context clues. Is profit declining due to decreasing revenues, or increasing costs (or do we not know yet)? Is profit decline a client-specific issue, or an industry-wide phenomenon (or do we not know yet)? This is all crucial context, so take notes throughout the case.
While Victor Cheng’s initial framework can help you get situated, you need to begin drilling deeper and deeper into the fundamentals of the case. While Victor notes that you should always segment, this still isn’t good enough.
Thus, to ultimately ace this type of case, you need to be asking yourself these three questions (if they are otherwise unidentified at the start of the interview):
Is profit decline a client-specific issue, or an industry-wide phenomenon? If it’s industry-wide, then competitors are also facing a similar issue, and for our client they may consider exiting the market. If it’s a client-specific issue, however, that leads us to our next two questions…
Is profit declining because of decreasing revenues?
Or is profit declining because of increasing costs?
To answer these questions, our framework must address these two core areas - revenues and costs - along with other key areas - like competition and market dynamics, customers, cost structures, and more - to get to the bottom of what is driving our client’s unprofitability.
REVENUES
Let’s start with revenues. Simply put, revenue is ‘price x quantity’. When you’re solving the case, though, this is too reductionist an approach.
For starters, understand what “price” means in the context of the case. In its simplest form, “revenue = average price x total quantity.”
However, instead of looking at average prices you should be looking at prices - and therefore revenues - by product / customer / geography / etc. segments. Average prices don’t necessarily weight said segments appropriately – and many insights can be uncovered by drilling into particular groups.
For instance, one product segment may be the key driver to declining revenues (re: lagging sales relative to other product segments), whereas another product segment is highly profitable and rapidly growing. Boom: case closed.
On that note, revenue may not always segmented by product — if your client is a subscription-based company like Netflix, you should call price “total spend per customer” and then segment that based on subscription tiers.
However, knowing the equation is only the beginning. Knowing what impacts revenue growth (and decline) is the key to acing the case. Here are some key questions you should be asking yourself to identify a particular case’s revenue drivers:
PRICE
Overall market demand - Is the product or service becoming a commodity with multiple providers offering identical options? Is fundamental demand declining for the product (i.e. typewriters, Blackberry phones, etc.)?
Competitors – Are they driving price down by offering cheaper products or a comparable product for a cheaper price? Are cheap substitutes widely available?
Customers – How much buying power do they have? Are they negotiating for lower prices through bulk discounts?
QUANTITY:
Overall market demand – Is it increasing or decreasing (re: is the demand for face masks increasing or decreasing?) If demand is decreasing, you can expect to see declining quantities sold across the whole market, both for the client and its competitors. (This would also affect prices – it would start a price war as competitors would fight for a shrinking pool of customers.)
Competitors – Are competitors stealing customers (market share)? How so — are competitors offering a more attractive product or service?
Customers – Are we meeting their needs? Have their needs changed, or have they found a competitor or substitute that better meets their needs? Are we missing out on targeting an attractive customer segment?
Channels – Are we marketing and selling through channels that are relevant to our key segments (re: if our customer is buying shoes on the Internet and we have a retail store, we’re not selling through the right channel, and vice versa)?
Depending on the situation of the case, you may or may not want to include the above factors in your framework. Some may be more relevant than others, and your job as a candidate is to demonstrate that you can efficiently hunt for the right data at the right time for the right client and the right situation.
With that said, here is a general approach you can employ when setting up your framework for profitability/revenue-type cases (in some cases you may be told this data upfront, so apply these rules accordingly on a literal case-by-case basis:
Request information on current sales volumes and pricing and historical volumes and pricing. If revenues have stayed the same over the years, then revenue is clearly not responsible for the client’s decline in profits. If revenues have decreased over the years, however, then it most certainly is.
Request information on competitor revenue models (volume and pricing). This data will help you see if this is an industry-wide issue or a client-specific problem. It may also potentially tell you if the client is missing out on profitable business activity that its competitors are currently cashing in on.
Identify “bang” areas (re: consulting slang for revenue streams that account for a large percent of total revenues and/or a large percentage of revenue growth). You can do this by analyzing key segments and identifying meaningful changes in their corresponding volumes and prices.
Assess whether any changes could be made to improve overall Revenues, Revenues by segment, or Revenues per unit sold.
Ways to increase prices: is the product sufficiently differentiated and unique to justify higher prices? Can we increase customer loyalty and stickiness? Do we have close competitors or substitutes that are cheaper than our suggested price hike (and will they take advantage of this)? Is our product price-elastic or price-inelastic? If price-elastic then we should lower prices to increase volume and revenues. If price-inelastic then we should increase prices to increase revenues.
Ways to improve volumes: can we identify changing customer desires / demands and respond accordingly (re: product development / iteration)? Can we launch a massive marketing campaign to boost demand? Can we expand distribution channels, sales force and customer service teams, or production capacity? Would we be able to to make an acquisition or enter a joint venture? Can we assess which products/divisions have the largest growth opportunities and allocate our investments accordingly?
EXPENSES
Expenses, or costs, can be split into Fixed and Variable, where the sum of both is equal to “Total Costs.” Fixed Costs and Variable Costs can be defined as follows:
FIXED COSTS
Fixed Labor – Have salaries of management or required staff increased?
Marketing – Has the client increased spend without seeing a related increase in sales? Is there an opportunity to use the marketing budget more effectively?
Overhead (i.e., rent, utilities, administrative) – Are these increasing? Is there an opportunity to decrease spending without impacting operations?
Interest/Depreciation (i.e., on mortgages, leases) – Are rates increasing? Has the client made a major capital investment?
Other Fixed Costs (re: insurance, case-specific factors) – Are costs increasing?
VARIABLE COSTS
COGS (re: input costs) – Are costs rising due to market factors such as an increase in energy/raw material prices? Is there an opportunity to negotiate with suppliers or switch to lower cost options?
Variable Labor – Are costs dependent on how much is produced/serviced? Have wages increased without a corresponding increase in price?
Distribution Costs (re: fuel, shipping, etc.) – Are costs rising, perhaps due to changes in transportation (i.e. rising fuel prices)?
Other Variable Costs (re: storage, variable utilities, packaging) – Are costs increasing? Have the client’s providers raised their prices?
Again, depending on the situation of the case, you may or may not want to include the above factors in your framework.
Here is a general approach to set up your framework for profitability/expense-type cases (in some cases you may be told this data upfront, so apply these accordingly):
Gather current expense breakdown and historical expense breakdown. If costs have stayed the same over the years, then it is clearly not a key driver.
Identify “bang” areas (re: expenses that account for a large % of the total). Bang areas are key drivers, and they’re the first ones on the budget cutting board to help the client cut costs, save money, and increase profits. You can accomplish by analyzing key Fixed and Variable expense components and identify any meaningful changes in expense areas over time.
Request information on competitor cost structures from the interviewer to see where your client’s cost structure may be inefficient.
Assess whether any expense areas could be cut with minimal or no impact on sales. If you cut down on costs but revenues correspondingly drop, then on net you aren’t seeing any returns on profits (which is what ultimately matters most!)