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FACTORS AFFECTING THE
PROFITABILITY OF AN ICT SME
Rotterdam, Brussels, Joensuu
28.11.2011
Teppo Tarnanen
North Karelia University of Applied Sciences
• Key success factors of any firm in any industry
–
–
–
–
Human resources (skills, competencies, knowhow)
Technological resources (material and immaterial)
Financial resources
A product: a physical good or an immaterial service or
their combination
– A large enough market, that is: enough buyers
• These have to be found, secured and developed
• The most important one is the human factor: the
knowledge, skills and competencies of the
employees on all levels including management
• The second most important one is the market: without clients
(buyers) the whole exercise is useless.
• A product is needed, but products come and go. The best product in
the market today will be forgotten tomorrow.
• Try to involve your clients in your product development, that may
extend the life cycle of your product as well as the life cycle of your
firm.
– Often a demo or a mock product can be made with a shoe string budget
for marketing purposes.
• Naturally suitable technology (such as hardware and software in IT)
is needed, but without competent staff technology cannot be utilised.
• Normally you will find the financial resources if you have a good
business plan and a credible team to realise the plan.
– Often a demo or a mock product can be made with a shoe string budget
for the purpose of negotiating with investors.
A FIRM IN THREE MARKETS
FACTORS OF
PRODUCTION
1. labour, entrepreneurship
2. buildings, machines,
equipment, vehicles,...
3. raw materials, energy,…
OUTPUT:
FIRM
COSTS
Interest
GOODS AND /
OR SERVICES
or combinations
of them
REVENUE
Equity
Repayment
Loan
LIABILITIES AND EQUITY:
1. LIABILITIES (vieras pääoma)
-loans from banks and other financial
institutions
-long term (>1 year), short term (<1 year)
2. SHAREHOLDERS' EQUITY (oma pääoma)
-from (old and new) owners (investors)
3. FINANCIAL MARKET
Rahoitusmarkkinat
2. GOODS AND SERVICES MARKET
Tuote/palvelumarkkinat
1. FACTORS MARKET
Tuotannontekijämarkkinat
INPUT:
A FIRM IN THREE MARKETS
In a market
o quantities traded
o and the price
are determined in the interaction of buyers
and sellers (demand and supply)
A firm in three markets
Market 1: Factors market
1. FACTORS MARKET
Tuotannontekijämarkkinat
INPUT:
FACTORS OF
PRODUCTION
1. labour, entrepreneurship
2. buildings, machines,
equipment, vehicles,...
3. raw materials, services,
energy,…
COSTS
FIRM
A firm in three markets
Market 2: Goods and services market
OUTPUT:
FIRM
GOODS AND /
OR SERVICES
or combinations
thereof
REVENUE
2. GOODS AND
SERVICES MARKET
Tuote/-palvelumarkkinat
A firm in three markets
Market 3: Financial market
FIRM
Interest
Equity
Loan
Repayment
LIABILITIES AND EQUITY:
1. LIABILITIES (vieras pääoma)
-loans from banks and other financial institutions
-long term (>1 year), short term (<1 year)
2. SHAREHOLDERS' EQUITY (oma pääoma)
-from (old and new) owners (investors)
3. FINANCIAL MARKET
Rahoitusmarkkinat
Profitability?
TOTAL REVENUE
–
TOTAL COSTS
=
PROFIT OR LOSS
• absolute profitability: monetary terms (€, £, $, ¥, …)
o margins: gross margin, EBIT, net profit
• relative profitability (1): a ratio, some of the margins in
relation to turnover (%)
o gross margin percentage, EBIT percentage, net
profit percentage
• relative profitability (2): return on investment (ROI, %)
Profitability
A simple profit and loss statement
TURNOVER
- variable costs
GROSS MARGIN
- fixed costs
OPERATING PROFIT BEFORE DEPRECIATION (EBITDA)
- depreciation
OPERATING PROFIT (EBIT)
- interest
PROFIT BEFORE TAXES (stop here in the case of a sole entrepreneur,
a partnership or a limited partnership) (Finland)
- taxes (on profit)
NET PROFIT
(continue here only in the case of a limited
company) (Finland)
Profitability
A PROFIT AND LOSS STATEMENT WITH RATIOS
TURNOVER
- variable costs
GROSS MARGIN
- fixed operating costs
OPERATING PROFIT BEFORE DEPRECIATION
- depreciation
OPERATING PROFIT (EBIT)
- interest
PROFIT BEFORE TAXES
- taxes
NET PROFIT
250000 100,0 %
150000
100000 40,0 %
60000
40000 16,0 %
25000
15000
6,0 %
5000
10000
4,0 %
2800
7200
2,9 %
PROFITABILITY
• Which of the firms is better?
PROFIT
TURNOVER
PROFIT / TURNOVER
EQUITY (OWNERS’ INVESTMENT)
PROFIT / EQUITY
FIRM A
10000
100000
10,0 %
Better!
80000
12,5 %
FIRM B
10000
200000
5,0 %
50000
20,0 %
Better!
REVENUE
• Revenue consists of a price and a quantity component:
REVENUE = PRICE * QUANTITY
• When budgeting, we must accept UNCERTAINTY
regarding both price and quantity
• Example:
BUDGETED
TURNOVER
200000
€/a
• WHY was there a difference?
 Let’s look at the components
ACTUAL
180000
€/a
DIFFERENCE =
ACTUAL – BUDGETED
-20000
€/a
REVENUE
• TURNOVER = PRICE * QUANTITY
BUDGETED
Case 1
TURNOVER
quantity
price
Case 2
TURNOVER
quantity
price
Case 3
TURNOVER
quantity
price
ACTUAL
DIFFERENCE =
ACTUAL - BUDGETED
200000
1000
200
€/a
units/a
€/unit
180000
900
200
€/a
units/a
€/unit
-20000
-100
0
€/a
units/a
€/unit
200000
1000
200
€/a
units/a
€/unit
180000
1000
180
€/a
units/a
€/unit
-20000
0
-20
€/a
units/a
€/unit
200000
1000
200
€/a
units/a
€/unit
180000
750
240
€/a
units/a
€/unit
-20000
-250
40
€/a
units/a
€/unit
REVENUE – BY CUSTOMER
• A useful exercise: who actually buys your services?
Products 1. Product
(or product
Customers
group)
2. Product
(or product
group)
3. Product
(or product
group)
Total
1. Customer group quantity
quantity
quantity
average price
average price
turnover
(customer
group 1)
turnover
quantity
turnover
quantity
average price
average price
turnover
quantity
turnover
quantity
average price
average price
average price
turnover
(customer
group 3)
turnover
quantity
turnover
quantity
turnover
quantity
Turnover
turnover (prod 1)
turnover (prod 2)
turnover (prod 3)
(firm total)
average price
turnover
2. Customer group quantity
average price
turnover
3. Customer group quantity
Total
turnover
(customer
group 2)
REVENUE – FURTHER NOTICE
• Remember price elasticity of demand (PED):
•
•
•
•
How sensitively does quantity demanded change when price
changes?
RELATIVE CHANGE
IN QUANTITY DEMANDED (%)
PED =
-----------------------------------------------RELATIVE CHANGE IN PRICE (%)
PED is always negative: quantity demanded changes in opposite
direction than price.
Demand is ELASTIC if the change in quantity demand (%) is larger
than the change in price (%).
Demand is INELASTIC if the change in quantity demand (%) is
smaller than the change in price (%).
How does the demand of your product behave?
COSTS
TOTAL COSTS =
FIXED COSTS + VARIABLE COSTS
• Variable costs depend directly on output
• Fixed costs do not directly depend on
output but rather on capacity - size of the
firm - or on the course of time.
VARIABLE COSTS
• Examples of variable costs:
o Cost of labour in production
o Subcontracted services (e.g. in IT projects)
o Raw materials, components etc. (alternatively:
merchandise) – less important in IT industry
o Electricity (power used in production; not in IT)
o Possible commission (directly related to the amount or
value of goods sold)
o Other?
These costs ”zoom” according to the volume of
output.
Fixed costs
• Examples of fixed costs:
o
o
o
o
o
o
o
o
o
o
Research, product development, design
Sales, marketing and distribution
Travelling, telecommunication
Rent of premises, lease of equipment etc.
Depreciation of premises, machines, equipment, vehicles etc. (those that
are not rented)
Maintenance of premises, machines and equipment
Marketing, administration, management and other labour cost not directly
related to production
Heating, lighting, electricity, office supplies, accounting, …
Interest (cost of finance)
Other?
These costs do not ”zoom” according to the volume
of output.
COST-VOLUME-PROFIT
ANALYSIS
• Cost-volume-profit analysis studies how
sensitively do changes in quantity, price
and different costs affect profit margins.
• Cost-volume-profit analysis assumes that
both variable costs and revenues depend
on output in a linear way. This is illustrated
in the following diagram.
COST-VOLUME-PROFIT
ANALYSIS
Cost-volume profit analysis assumes that both variable costs and revenues depend on
output in a linear way. This is illustrated in the following diagram.
Cost, revenue (€)
Total revenue (€)
Contribution margin
Profit (€)
Total costs (€)
Profit = 0 in the
break-even point
Fixed costs (€)
Loss (€)
Variable costs (€)
Break-even point (€ or units)
Margin of safety (€, units, %)
Actual output (€ or units)
Output and
sales (€ or units)
COST-VOLUME-PROFIT
ANALYSIS
WHAT IF …?
EXAMINE HOW SENSITIVELY DO CHANGES IN OUTPUT,
PRICE, VARIABLE COSTS OR FIXED COSTS AFFECT THE
MARGINS AND THE PROFIT.
CHANGES IN
OUTPUT AND
CHANGE IN
CHANGE IN CHANGE IN
INITIAL
SALES
SELLING PRICE VARIABLE
FIXED
SITUATION VOLUME (%)
(%)
COSTS (%)
COSTS (%)
3%
5%
10 %
10 %
Capacity
Output and sales (units/week)
Selling price (€/unit)
Variable costs (€/unit)
Contribution margin (€/unit)
Fixed costs (€)
1500
1200
350,00
250,00
100,00
100000
1236
350,00
250,00
100,00
100000
1200
367,50
250,00
117,50
100000
1200
350,00
275,00
75,00
100000
1200
350,00
250,00
100,00
110000
Turnover
Variable costs
Contribution margin
Fixed costs
Profit
420000
300000
120000
100000
20000
432600
309000
123600
100000
23600
441000
300000
141000
100000
41000
420000
330000
90000
100000
-10000
420000
300000
120000
110000
10000
ROI: DUPONT DIAGRAM
TURNOVER
250000
100 %
VARIABLE COST
150000
60,00 %
TULOSLINJA / PROFIT LINE
GROSS MARGIN
100000
40,00 %
FIXED COST
EXCLUDING
DEPRECIATION
60000
24,00 %
OPERATING
MARGIN
40000
16,00 %
DEPRECIATION
25000
10,00 %
OPERATING PROFIT
(EBIT)
15000
6,00 %
PROFIT MARGIN
RATIO
6,00 %
TURNOVER
250000
ROI
RETURN ON INVESTMENT
10,00 %
TURNOVER
250000
FIXED ASSETS
100000
CAPITAL TURNOVER
1,67
INVESTMENT
(≈ BALANCE SHEET
TOTAL)
150000
CURRENT ASSETS
(INVENTORIES AND
FINANCIAL ASSETS)
50000
PÄÄOMALINJA / BALANCE SHEET LINE
SUMMARY
• Is there a single indicator to indicate how
well a firm performs?
• Yes? ROI summarises nicely many things.
• But NO
o We need at least four types of indicators
o GROWTH
o PROFITABILITY
o LIQUIDITY
o SOLIDITY
THANK YOU!