Businesses are constantly searching for ways to improve profits. As a business leader, understanding the drivers of your profits and how they contribute to your bottom line is crucial to achieving sustainable growth.
Many business leaders operate without a strategy driven by what is “really” happening in their business. This leads to poor execution, bad investments, fixing the wrong problems, or the business failing to perform to its full potential.
By utilizing nontraditional tools and methods to analyze the underlying components that drive profitability, you can identify new opportunities to optimize your revenue streams, minimize costs, and maximize your overall success.
Within the reach of every business leader are the tools and techniques that can provide targeted insight and direction. Unfortunately, some businesses just shouldn’t be operating in the markets they do or at all. The tools and techniques illustrated in this article will help determine that, too.
It is time to learn how to take your business to new heights by unlocking the secrets of profitability.
Start and build on business fundamentals.
So, what are the high-level steps in developing an effective business strategy to improve profits?
Identify what makes up profit.
Analyze what components if improved, would make the most significant impact.
Strategize and develop tactical plans to improve the most impactful components.
Execute tactical plans.
Measure and adjust.
Revisit regularly.
Don’t be fooled by the simplicity. Creating the optimum business strategy takes awareness, knowledge, thought, effort, and a willingness to see and correct the good, the bad, and the ugly.
Let’s begin with the first step of accurately identifying what makes up profit. Constructing a profitability tree is one of the most creative and effective business framework-based tools to understand what contributes to business profits.
A profitability tree, or a profit analysis tree, is a specialized decision tree [1] utilized to analyze, diagnose, and break down the components of a company's profitability. It helps visually understand, deconstruct, and explore factors contributing to the overall profit. It is beneficial for identifying the components or profit drivers and the precise areas where performance can improve.
Many business schools and consulting firms work to ensure that the creation and understanding of decision trees, like profitability trees, are mastered for one reason. They work!
This multi-purpose business framework is highly effective in tracing, understanding, and fixing the root cause of many business problems.
If you are interested in learning more about business frameworks, take a moment to read about what they are and how they can fast-track business insight and solutions. An introductory article on frameworks, Learn the Consulting Secret to Fast Track a Solution, is available at the Rock Pine Partners Blog. [2]
Profitability trees and their close cousins, standard financial reports, like income statements [3], are used in business and finance to analyze a company's performance and financial health. There are significant differences. The following table compares the attributes of a profitability tree and an income statement.
In short, income statements are standardized financial reports providing a broad overview of a company's financial status. Profitability trees are more creative analytical tool that help visually dissect and understand the various elements contributing to a company's profitability. They are a tool that business leaders and non-CFOs or accountants can use to visualize, understand, and model what is going on in a business.
What does a Profitability Tree look like?
The structure of a profitability tree visually deconstructs costs and revenue drivers in a business down into profit-driving components.
A profitability tree can encompass the entire business, a profit-producing segment, or a specific business area. Most companies have the information in report format from the accounting, human resources, payroll, sales, and enterprise resource planning (ERP) systems.
Depending on the level of analysis, a profitability tree may optionally connect and illustrate targeted optimization strategies to improve the cost or revenue driver's performance.
Revenue and Cost
At the highest level, profitability is most often broken down into two main components: revenue and cost.
Revenue Breakdown
Revenue is divided into different components, such as the number of units sold, the average price per unit, the number of billable hours, the average billable rate per hour, the number of clients, the average revenue per client, etc.
Cost Breakdown
Costs are often divided into two main pairings: direct and indirect or variable and fixed. This division is driven by the type of profit being analyzed.
Direct Costs
These costs are directly traceable to a specific cost object, such as a product, service, or project. Examples include direct labor, direct materials, and manufacturing supplies used to produce a specific item.
Indirect Costs
These costs cannot be directly linked to a specific cost object. They are often termed as overhead and include expenses like rent, utilities, and administrative salaries. These costs support the business as a whole and are not directly tied to any single product or service.
Variable Costs
Variable costs change in proportion to the level of production or activity. Both direct and indirect costs can be variable. For instance, direct material costs are variable (a type of direct cost) as they increase with more units produced. Similarly, utility expenses might vary (a type of indirect cost) based on production intensity.
Fixed Costs
Fixed costs remain constant regardless of the level of production or activity. These can also be direct or indirect. A direct fixed cost example could be a piece of machinery purchased for production with a set cost. An indirect fixed cost example is rent for a factory, which remains the same regardless of how much is produced within the factory.
A tip to help break down costs is to create a simple grid from accounting reports and list out the costs.
To simplify the process, costs with a fixed and variable component or "mixed costs" can be attributed to the cost type (variable or fixed) with the largest financial impact. It is also okay to add mixed as another main category of costs. Remember, a profitability tree is an internal diagnostics and analytics tool and is not required to follow generally accepted accounting standards as a regulatory report, so any logical grouping is perfectly acceptable.
Revenue and Cost Segmentation
Revenue and costs should be broken down into logical categories or groupings. Costs can be divided into costs to make or acquire, costs to sell, costs to provide services, and general administrative costs, subdivided into more specific costs or expense types, and so on. Revenue components can be divided by geography, sales vehicle, customer, product, or service types, etc.
Determining the best way to classify, group, and deconstruct the cost and revenue components and determining how deep to go is the most challenging part of identifying what makes up a profit.
Optimization Strategies
These targeted strategies become tactical plans created to improve a specific revenue or cost item and overall profitability.
What can be done with a profitability tree?
Once created, a profitability tree is a powerful tool for analyzing and understanding the factors affecting a company's profitability. It can be used to break down and examine different components driving profit, such as revenue streams, cost structures, and profit margins, and help to identify and model targeted strategies for improving bottom-line performance. Profitability trees can be revisited regularly to track performance, spot new trends, and adjust business strategy to real-time market conditions.
The basic concept can even be applied to the public sector and not-for-profit organizations. Any entity that has a cost and revenue structure.
Effectively utilizing profitability trees requires a firm grasp of business skills, including basic accounting and finance, company and industry knowledge, curiosity, and creativity.
Some of the areas profitability tree analysis can provide insight into include:
Revenue Streams
Identification of the various sources from which a business earns money. This includes product sales, services, subscriptions, license fees, commissions, investments, or other income-generating activities.
Cost Structures
Identification of the various sources from which a business spends money. Understanding these costs is crucial for managing expenses and maximizing profit.
Profit Margins
Understand profit margins for different products or services, highlighting which areas are most profitable and which may need improvement or reevaluation. It can break down margins by product lines, business units, geographic regions, sales grouping, and more, providing insights into where the company is most and least profitable.
Price Optimization
Allows for the analysis of different price points for products or services to determine the optimal pricing strategy.
Market Dynamics
Can shed light on how market conditions and competition affect profitability. This includes understanding the demand, supply, pricing strategies, and external impacts.
Drive Targeted Marketing
Drive specific revenue impacts by aligning and modeling the impacts of marketing efforts and campaigns.
Operational Efficiency
Can highlight areas where operations may be streamlined or improved to reduce costs and increase efficiency, thereby boosting profits.
Investment Decisions
By analyzing and modeling profitability, businesses can make informed decisions about where to invest or divest for future growth, such as in new technology, product development, or market expansion. This could be used to understand the ROI of the impact of the investment in a new enterprise resource planning (ERP) solution or AI program.
Strategic Planning
Aid in creating strategic goals and tactical plans by identifying potential growth areas, costs, and risks that could be better managed to drive a profit result.
Performance Measurement
Provides a basis for measuring the performance of different organizational departments or units, helping in effective management and resource allocation.
People Strategies
Insight into the impacts and trade-offs between hiring, contracting, outsourcing, or automation.
Pricing Strategies
Can help determine and set appropriate pricing strategies that maximize profit while remaining competitive.
Risk Management
Enable proactive risk management by identifying financial risks and areas of vulnerability in the business model.
Benchmark Comparisons
Allow the ability to compare how a business, product or service line, costs, and more measure up to their peers or a best-in-class.
Let’s work through an example based on a hypothetical consulting firm with declining year-to-year profits. The business leadership of the consulting firm has some high-level theories on why profits have fallen and would like to understand the main drivers and identify targeted and fact-driven strategies to improve profit performance.
A good starting point is to look at building a profitability tree. This requires isolating the revenue and cost drivers by identifying and quantifying what has the most impact on profit.
A few things that are known about the firm.
The primary service is hourly business consulting. Like most consulting firms, the labor cost to deliver services is the most significant expense.
It has no partners and a small team of salespeople driving sales or revenue.
There have been no significant changes in the service offerings. The firm currently delivers the same services it did in the prior year.
There have been no extraordinary costs (settlements, taxes, fees, etc.).
The following high-level profitability tree was developed after reviewing financial information and interviewing the business leadership and staff to learn how the business generates revenue and spends.
Current year profitability tree for the sample consulting firm
Prior year profitability tree for the sample consulting firm
This example focused on a few primary revenue and cost drivers to illustrate key concepts and the application of the profitability tree process.
A full profitability tree would include a more comprehensive view of the consulting firm’s inner workings, including examining and deconstructing specific revenue and cost characteristics to gain a more nuanced understanding as the branches of the tree reveal themselves and can be quite creative.
The tree could be broken down and analyze employee and contractor specialty and expertise levels by staff experience and skill across various human resources, accounting, operations, and legal departments.
We could investigate the various elements that make up the total cost of an employee, including benefits, salaries, bonuses, training expenses, supplies, laptops, software, and more.
We may also consider the expenses of opening and maintaining an office and the business, like rent, utilities, supplies, and systems.
Further revenue dimensions for investigation could include a detailed look at marketing and sales expenses, sales productivity by person or office, the number of clients, new sales, solicitations answered and won, the quantity and nature of engagements, acquisition source, the types of services offered, contract durations, key engagements, and more.
Returning to our example based on the profitability trees for the current and prior year, we can now analyze the consulting firm’s performance, identify reasons for the decline in profit, examine other areas that should be investigated, and propose next steps and strategies to maximize improvement.
What we learned from this example.
Firm’s Performance Year to Year Performance
Revenue was a consistent $20 million over both years.
There was no sales growth from period to period.
Billable hours remained the same at 80,000 for both years.
There was no change in the client bill rate for either year.
Gross profit declined from $3.5 million to $2 million.
The gross profit margin decreased from 17.5% to 10.0%.
Drivers for Profit Decline
Overall Costs
Costs increased from $16.5 million to $18 million on flat revenue
Client Bill Rate
Bill rate remained constant at $250 per hour on increased billable staff (contractors and employee consultant) costs
Employee Costs
There was an increase in the cost of employee consultants from $4.5 million to $6 million.
There was an increase in the total number of employee consultants from 25 to 30, or a 20% increase in headcount from the prior year.
There was a significant rise in per-employee consultant costs by $20,000 per consultant.
The average loaded billable employee consultant cost per hour increased from $95.74 to $106.38.
Employee consultant utilization decreased from 85.1% to 70.9%, indicating that a smaller percentage of employee consultants' time was billed to clients in the current year.
Employee consultants had 7,000 and 16,400 hours of additional billable employee capacity in the prior and current year, respectively.
Contractor Costs
The firm paid contractors $165 per hour in the prior year and $175 per hour in the current year, indicating increased contractor rates.
The number of hours the firm leveraged contractors remained constant at 40,000.
Sales Staff Costs
There was no sales or revenue growth.
Sales staff costs decreased from $1.4 million to $1 million.
The number of sales employees reduced from 7 to 5.
Areas to Investigate Further
We have learned quite a bit about the firm, and now, with an understanding of the main profit drivers, we can ask data-driven and informed targeted questions to understand further why profits are declining and zero in on some solutions.
Consultant Employee Headcount Increase
Examine why the number of employee consultants increased.
Was there a need for specific talent?
Were there new sales that were delayed or canceled?
Consultant Employee Cost Increase
Examine why the employee consultant cost increased.
Was there a need for specific talent?
Did the employment market influence this?
Who received the increase, new or existing employees, and what types of employees?
Employee and Contractor Utilization
Assess why there is a lower utilization rate and whether there are efficiency issues or insufficient client work.
Assess why contractors are utilized when there is excess employee staff capacity.
Consider if any contractors with unique skills and experience can be converted to lower-cost employees.
Costs of Sales and Marketing
Evaluate the effectiveness of sales and marketing expenses in generating business.
Pricing Strategy
Examine if the pricing strategy is aligned with industry standards and if there is room to increase billable rates without losing clients.
Overall Gross Margin
Examine if the margin results are aligned with industry standards and trends.
All Non-Consultant Employee Costs (sales and supporting) Remained Constant
Examine why the non-employee consultant cost remained constant, but consultant costs increased.
Are non-consultant employee costs expected to require increases in the future?
Non-billable Costs
Scrutinize the unreimbursed project expenses and understand why these costs are not being billed to clients.
Immediate Actions for Improvement
A working model has now been created, illustrating how the consulting firm produces profit. This will help select and analyze the impact of any actions. We can immediately consider executing several actions as part of an overall strategy to improve overall profit.
Enhance Employee Utilization
Implement project management and resource allocation tools to improve the billable utilization rate of employee consultants.
Consider staff reductions or retraining employee consultants not utilized or above break-even cost.
Optimize Contractor Engagement
Analyze the cost-benefit of using contractors and consider reducing financial impact and reliance on them by renegotiating rates, retraining employees, converting contractors to employees, or seeking alternative contractor sources.
Align Sales Force
Reevaluate the sales team structure and compensation to align with business generation needs.
Determine the optimal sales team size and marketing spend to drive revenue
Control Client Costs
Tighten control over unreimbursed expenses and ensure that project-related costs are passed on to clients where appropriate.
Develop Training Programs
Invest in training for consultants to take on billable activities.
Review sales and planned work pipeline to align skills to maximize future billable utilization
Improve Operational Efficiency
Streamline operations to reduce fixed costs could involve renegotiating rent or reducing office space if remote work is feasible.
Often, there is a natural inclination to focus on cost issues as they are often easier to identify and improve. Improving both costs and revenues simultaneously can lead to a significant positive impact on profits.
There is an important saying to remember, “You can only squeeze just so much juice out of a lemon.” Cost control is necessary, but expansion of the revenue side of the equation is essential to a business’s long-term health, growth, and stability.
What else can the firm do to improve profitability?
We now have targeted actions for bottom-line improvement supported by an informed understanding of the firm's profitability drivers. We could stop our example here or expand on the momentum by considering and gaining additional business and industry knowledge and insight to assess and understand the industry dynamics, competitive position, and the effectiveness of operations, human resources, marketing, sales, and more.
The following visual representation highlights the many steps the firm could consider next to understand, refine, and build on the profitability tree.
SWOT Analysis (Strengths, Weaknesses, Opportunities, Threats)
Strengths and Weaknesses
Evaluate internal factors such as the firm’s resources, capabilities, and business processes.
Opportunities and Threats
Examine external factors such as market trends, economic conditions, and competitive actions.
Porter’s Five Forces
Assess the competitive intensity and attractiveness of the consulting firm's industry by analyzing the five forces: the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers, the threat of substitute products or services, and competitive rivalry.
PESTEL Analysis (Political, Economic, Social, Technological, Environmental, Legal)
Evaluate the macro-environmental factors that might affect the industry and how they could impact the firm’s strategy.
BCG Matrix (Boston Consulting Group Matrix)
Analyze the firm’s service portfolio in terms of market growth and market share to prioritize investment in different service areas.
Value Chain Analysis
Dissect the company’s operations to understand where value is added and identify cost savings or quality improvement opportunities.
Ansoff Matrix
Identify growth strategies by examining new vs. existing markets and new vs. existing services.
Blue Ocean Strategy
Explore uncontested market spaces to reduce competition and create demand through innovation.
Balanced Scorecard
Implement a performance management system that examines financial measures while considering customer satisfaction, internal business processes, and the firm’s learning and growth.
Sales Funnel Analysis
Analyze the company’s sales funnel to assess conversion rates at different stages and determine where improvements could be made to increase sales.
Customer Segmentation and Targeting
Divide the customer base into segments to tailor marketing and sales strategies effectively.
Marketing Mix (4Ps: Product, Price, Place, Promotion)
Review the firm’s approach to its service offerings, pricing strategy, distribution channels, and promotional activities.
CRM Analysis (Customer Relationship Management)
Look at the systems for managing interactions with current and potential clients to improve business relationships.
Executing one or more of these frameworks can help the sample consulting firm better understand its market position, identify strategic opportunities and threats, optimize operations, and craft effective growth strategies. They are most potent when combined or built upon to provide a comprehensive view of the business environment and internal capabilities.
Where should we start, and what would be a good next step beyond the initial profitability framework strategies?
The choice of which business framework to start with depends on the specific context and pressing issues faced by the consulting firm. In this example, given the firm’s declining profits despite stable revenue, starting with a SWOT Analysis can provide immediate, actionable insights with a balanced focus on internal and external factors.
Once the SWOT Analysis is completed, the firm will have a clearer picture of its strategic position. If the analysis reveals that industry forces are impacting profitability, then Porter’s Five Forces can help to understand these dynamics. If the SWOT points to issues with the firm’s service offerings or market positioning, then the Ansoff Matrix or Blue Ocean Strategy are more appropriate next steps.
If the analysis highlights issues with cost structures or inefficiencies in operations, Value Chain Analysis can help pinpoint specific areas for improvement.
Finally, if the SWOT Analysis suggests that client relationships or sales processes are a critical area of weakness, then a CRM Analysis or Sales Funnel Analysis could be beneficial to improve conversions and client retention.
Apply it to your business.
Profitability trees are an effective multi-purpose tool worth the time investment to master. They allow businesses a proven method to analyze their profit drivers and identify improvement areas systematically. They can help answer questions like which products and services are most profitable, which costs are disproportionately high, where efficiency improvements can be made, and allow a host of what-if scenarios. This visual and analytically supported approach is vital to informed strategic decision-making, operational improvements, and long-term planning. With some effort, profitability trees can be a game-changer that measurably improves business performance.
Now, go and apply to your business to see what you find!
Appendix:
Profitability Tree Supplemental Analysis Calculations for the Sample Consulting Firm
Current Year
Prior Year
References and Citations
Harvard Business Review website, https://hbr.org/1964/07/decision-trees-for-decision-making, “Decision Trees for Decision Making”, John F. Magee, July 1964, accessed December 10, 2023
Rock Pine Partners website, https://www.rockpinepartners.com/post/learn-the-consulting-secret-to-fast-track-a-solution, “Learn the Consulting Secret to Fast Track a Solution”, Greg Valyou, November 13, 2023
Corporate Finance Institute website, https://corporatefinanceinstitute.com/resources/accounting/income-statement/, “Income Statement”, CFI Team, accessed December 10, 2023
Cover image, Microsoft Stock Image Photos, December 10, 2023
All other charts created by the named author, Greg Valyou
Disclaimer, Copyright and Trademark Statement
This article is provided for informational and educational purposes. It makes no warranties as to the claims, accuracy or fitness of information provided, referenced or cited. Use of the information, instructions, and any examples contained in this work is at your own risk. There should be no implied endorsement of this article by any person or organization referenced.
All trademarks, company, product and services names, images, descriptions, or public website content are property of their respective owner as source referenced. It is your responsibility to ensure that your use thereof complies with such license and/or right.
Comments