There are various system options for cost calculation in SAP, varying in value and features.
In this article, we will introduce a Brazilian alternative that not only integrates seamlessly with SAP but also specializes in cost and profitability calculation, offering numerous advantages for your organization.
For companies looking to optimize cost calculation in SAP, MyABCM stands out as a specialized option with many attractive features. Available on the SAP Store, the system integrates smoothly with SAP and offers a series of functionalities that allow companies to get a snapshot of their cost structures, simulate scenarios, and make more confident decisions.
MyABCM offers a series of advantages for companies wanting to efficiently calculate costs and profitability:
While many available solutions may represent a significant cost, MyABCM is more affordable, delivering valuable and efficient features. This makes it an attractive option for companies of various sizes, enhancing the return on investment.
MyABCM is notable for its ability to provide a high degree of cost traceability. This is essential for companies that want to understand the origin of their expenses, optimize pricing, comprehend the role of each product, service, and customer to the organization, and make informed decisions based on accurate data.
The ability to gain insights in less time is invaluable for companies that need to make agile decisions in a dynamic business environment. One of the major benefits of MyABCM is the speed of implementation, calculations, and information availability, combined with smooth data integration between SAP and its system.
MyABCM is used by large companies in more than 50 countries to calculate costs in SAP, covering a wide variety of sectors, including banking, industrial, governmental, healthcare, and many more. This global adoption is a confirmation of its effectiveness in meeting the needs of organizations of all sizes and in different segments, with flexible tools that adapt to the specifics of each business.
For companies looking for specialized solutions to enable integrated cost management within the SAP ecosystem, MyABCM stands out for being accessible and offering functionalities specifically developed to optimize the identification and calculation of costs, with excellent cost-effectiveness. Make this strategic decision: fill out the form below and speak with our experts.
Almost 30 years ago, in February 1997, the main headline of Forbes Magazine featured an article by Prof. Srikumar S. Rao from Columbia University, which showed that the lack of control over rising indirect costs could bring organizations to an end.
In the article, Prof. Srikumar cited the real example of a giant American company that found a growth opportunity with the bankruptcy of its main competitor. However, contrary to what it expected, it started making losses instead of increased profits!
Upon further investigation, this company surprisingly discovered that its “flagship” product was unprofitable, and other products it considered unprofitable were, in fact, the most profitable ones for the organization. This happened due to a poor allocation of indirect costs.
How could such a large and intelligent company make such a basic mistake? It was revealed that the organization was allocating depreciation and other indirect costs based on the direct labor cost.
A product that consumed 20% of direct labor also ended up taking 20% of depreciation and overhead costs. However, there was a major flaw here: labor doesn’t depreciate, machines do.
In areas where there is high labor consumption, less machinery is usually required. The moral of the story: products that consumed a lot of labor should have received less depreciation and overhead costs – exactly the opposite of what was calculated.
The danger lies in the fact that direct costs are easy to appropriate: it’s straightforward to know, for example, how much raw material is used in a product or how much cash is in a specific bank account. But what about indirect costs? How do we allocate them correctly and coherently, respecting a cause-and-effect relationship?
A failure in this process, in the medium and long term, is often the cause of business ruin. Improperly allocated indirect costs can be detrimental to your business.
It’s crucial to exercise caution with any cost modeling that mechanically allocates indirect costs.
And remember: depreciation is just one of many indirect items! Indirect costs can include everything from toilet paper in the bathroom to IT, HR, and support area costs. The “lazy” solution is to allocate them proportionally to production volumes, transactions, or revenue.
To complicate matters, these indirect costs are becoming more significant for several reasons. Among them, we can mention an increase in automation, which entails a clear “replacement of people with machines.” Additionally, the growing diversity of products, services, customers, channels, suppliers, and machinery (i.e., increased business complexity) results in higher indirect costs due to the increased administrative effort – the management effort needed to handle this complexity.
Historically, these indirect costs only increase. Consequently, the distortions caused by arbitrary apportionment also increase. It is common to find situations in companies where a product, believed to be the “flagship,” is unprofitable. On the other hand, products considered unattractive are often the most profitable for the company, responsible for maintaining the company’s margins in the black.
Imagine three friends decide to go out for dinner. The first one is on a diet and orders a salad with mineral water. The second friend orders a delicious steak with wine, and the third orders lobster with sparkling wine and dessert. At the end of the dinner, they split the bill equally among the three friends.
Does this splitting seem fair to you? It is easy to identify and even find these distortions absurd. However, these distortions happen every day in many companies worldwide!
Now, if you were to ask for separate bills for each friend, where each one pays only for what they consumed, we’re talking about ABC, “activity-based costing,” which potentially eliminates these distortions in organizations and adequately addresses these indirect costs.
With some practical examples, it’s easier to visualize the weight of indirect costs and understand how activity-based costing allows us to identify and allocate them more accurately.
Take a simple billing activity: its total cost consists of the combined salaries and benefits of the people involved in this activity.
Traditionally, this total cost would have gone into a pool of “general expenses” to be arbitrarily allocated. However, with ABC, you divide this value by a non-financial measure, such as the number of invoices generated Thus, you obtain the cost per invoice. Count the number of invoices generated per product, multiply by this value, and allocate it to each product – this is the value of the “Billing” activity for each of your products. In addition to eliminating distortions, we achieve an important KPI (key performance indicator) for business management: the value of invoicing per issued invoice.
With this data, cost reduction studies, possibilities for outsourcing, and even monthly monitoring can be applied – something that simply would not be possible before activity-based costing.
The cost of this activity relates to the HR department’s effort specifically involved in hiring employees. It must be separated from other activities, such as payroll processing, employee evaluations, training, etc.
Suppose that, in a given period, 10 people were hired. Out of these, 5 were for Production, 2 for Maintenance, and 3 for Sales. Therefore, the costs of this “Employee Hiring” activity should be distributed as follows: 50% to Production (which will subsequently be allocated to products, also by activities), 20% to Maintenance, and 30% to Sales.
Apart from being able to allocate the costs of this activity, we obtain a critical KPI for decision-making: the cost of hiring per employee – this value can be compared with the monthly expenses of the previous months, the company’s target, or even the cost of outsourcing this activity.
The potential here is not limited to indirect costs! Several direct costs, for example, production or customer service costs, can (and should!) be broken down by activities, as we will see in the examples below:
Imagine you work in a manufacturing company and have been tasked with cutting costs by 10%. What would you do?
The natural path here is to try to understand which actions you would implement for this cut, and for this, it is essential to understand how costs are currently distributed.
With a lot of creativity, some possible options to reduce costs could include:
Note that all these cost reduction options are linked to the information provided by the company. And since the only managerial information we have is the amount spent on these costs and expenses, we are limited to actions related to this!
Now… imagine for a moment if these same costs were broken down by activities, considering their direct and indirect costs. Some of them would undoubtedly include:
Note that some possible actions now include:
Notice that instead of focusing on specific expenses, we are now also managing by activities, understanding how much each one contributes to the company’s results, proposing improvements, and conducting much more efficient management.
Now, imagine the same previous example, but applied to a bank and with an activity breakdown as follows:
After calculating the activities, including the correct assessment of indirect costs, it was discovered that the “Credit Analysis” activity cost $900,000 per year. If the total number of analyzed credits was 3,000, we can understand that the cost of each analysis is $300.
The first question to ask is: what is the value of each credit analysis? This is because the cost of the process is often more expensive than the actual cost of the credit being granted!
next, it is essential to consider ways to reduce these costs. Out of the $300 for each credit analysis, it was discovered that $50 was spent only on employees’ overtime while entering the credit requests into the bank’s old credit system. This specific task of entering requests could be outsourced for $10 per credit. With just this activity, a cost reduction of $120,000 is achieved.
Other options include rethinking the entire process, digitizing the requests, and even benchmarking between units to try to improve. And mind you, we are talking about a single activity. Learn more about how to develop a cost-reduction project.
Imagine this potential now applied to all the activities in your company – the possibilities are infinite!
While arbitrary allocation of indirect costs can be fatal for a company, accurate allocation can lead to significant increases in profitability through cost cuts based on precise data.
Just like the companies in our examples, your organization can also benefit from cautious and safe cost reduction by observing the costs of each activity in great detail to expand profit margins.
Fill out the form below and find out how!
Before the Covid-19 Pandemic, Duke University research gathered 848 financial executives in the United States and asked, “What are your organization’s top three concerns?” The number one concern of these executives was “Being able to maintain margins.”
Another study, this time from Gartner, of 482 executives asked, “What is your biggest technological challenge?” The biggest challenge identified was “Properly measuring Product and Customer profitability.”
In other words: obtaining adequate profit margins has been a difficulty and a widespread concern among companies. In this article, we will shed light on some of the factors that may be causing this problem in your organization, and how you can reverse the situation.
In fact, we realize that the margins of organizations have fallen dramatically in recent years. This is due to several factors, such as the pandemic itself, pressure from government agencies, logistics problems, competition, and even increasingly demanding customers.
It is common to find companies that do not realize that one of their products is making a loss and continue to sell it below cost out of total ignorance! And in their eagerness to serve customers, organizations are often practically forced to give significant discounts – which in many cases ends up generating a loss-making sales operation, resulting in a significant impact on the overall profit margin.
In this context, it should be noted that those customers who demand a lot of effort from the organization are deficit customers. They are those who make special orders, impose a great logistical challenge of any nature, or require significant post-sales. Now imagine what it is like to sell to such a customer!
And, making matters worse, many of these clients are treated as “key” customers, because they buy a very large volume of goods (or in the case of the services segment, transact a large volume of services), often giving the false impression that they are “profitable” when in many cases they are loss-making!
On the “shop floor” the adversities are equally great. Every process or activity done in duplication, the rework, represents huge costs that the company must bear. Defective products or layout problems and high idleness are good examples.
If we go to the back office, several factors must also be evaluated in order to maximize the company’s profit margin. Is the size of the organization adequate for the challenges of producing, selling, delivering, and after-sales? Is there a way to be more efficient? These are some important questions.
These scenarios are reinforced by a study done at Harvard. The research found that on average, 20% of customers are very profitable, approximately 70% “stall”, and 10% are loss-making. The big challenge is to understand which ones they are and what to do with this information!
The issue of controlling profit margins is urgent for companies in all sectors. A pre-pandemic survey by Exame magazine pointed out that the average net margin of organizations in the last 10 years was 2.54%.
This means that a transaction made outside of compliance, or some additional discount offered to a customer is often the difference between profit and loss for the company.
From the moment we can measure costs and results properly, we can make the best decisions. Discount policies, salespeople commissioning, process outsourcing, exporting or not, opening new divisions, etc., are just some of the possibilities when we have true information for this decision-making.
Want to find out what is causing your company’s profit margin to drop and reverse this process? Contact our experts!
To begin, let’s briefly clarify what cost-to-serve is.
Cost-to-serve, widely referred to as CTS, is the sum of all the costs required to provide a product or service to your customer.
The fact that all costs are fully considered is what makes this analysis a high-performance strategy when looking at a customer’s profitability.
We usually associate a good customer with a customer who buys a lot from us – or with the one where we have a significant volume of services and transactions. But this only shows the one where we have had the most sales, not the one where we have made the most money, i.e. the most profitable! A customer with high turnover certainly requires a series of trade-offs and efforts that are often “expensive” to meet.
A study published in the Harvard Business Review showed that on average 20% to 30% of customers are very good from a profitability point of view – bringing between 150% and 300% of the company’s total profitability; on the other hand, between 50% and 60% are neutral (i.e., we do not make or lose money) and approximately 20% are unprofitable.
The big challenge is to understand which ones they are, and in which layer each one is located. Eliminating the clients that we lose money is not enough, as by doing this immediately other clients that are neutral and even those that make some profit start to become unprofitable – after all, our fixed costs don’t disappear, requiring us to make some adjustments in our installed capacity.
Now when we bring into the equation, in addition to the cost of serving each client, the profitability we have with each one and the time we will be serving to this client, we will certainly find situations in which that extremely profitable client will migrate to the competition in the short term; others that are extremely loss-making will continue to drain the organization’s resources. Bad scenario, isn’t it?
The question is, “what should we do?” The first thing to do is to be aware of the need to measure things. As we know, it is impossible to manage what you cannot measure – so measuring and then deciding is key!
“Firing clients”, + the end: those clients who are loss-making often help pay the fixed costs, and if there is no change in the structure of the organization, their “firing” may bring a terrible consequence, which is that clients who are neutral today may start to be unprofitable (and the very profitable ones may become not so profitable). There are companies that have already bankrupted just because of failure in this criterion, and they were excellent “producers”, with well-rounded production lines, equally good product costs, but they neglected this very important detail, which is to understand and act correctly with the costs-to-serve.
During the development phase, it is determined what the cost object is, what the cost of meeting this object will be and how it will be mapped, what the drivers for allocating the aggregate cost will be, and what IT systems will be used to calculate and maintain the analysis of its operation after the development of the customer’s profitability.
On one occasion a large national bank did a project and discovered that it had loss-making clients: What did they do? They eliminated these clients from their portfolio. The result: the clients that were neutral became unprofitable. What did they do then? They eliminated these new unprofitable clients, resulting in a huge loss with this operation. The issue of capacity/idleness must ALWAYS be taken into consideration for cost analysis!
It is also important to know that it is not by firing employees that we reduce costs – at least not indiscriminately. In fact, there are studies that show exactly the opposite: according to the US Conference Board, of the companies that tried to reduce costs, 30% actually had higher costs! Another study by Deloitte showed that 75% of the companies that laid off employees to reduce costs had to rehire others for the same positions within 1 year. And finally, McKinsey showed in a survey that only 10% of cost reduction projects are successful within 3 years of its implementation. Reducing costs is not simple, it demands effort and measurement (measure!) to make the best decisions afterwards.
Check out our content that fully explains the Activity-Based Costing system
The first step is to understand how the organization’s efforts are aimed at serving the various customers and channels; this includes information that must necessarily come from the CRM, but also from interviews with the sales and customer service areas.
Through the metrication of the main activities involved in serving these customers and channels it is possible to understand the effort spent to serve them individually and therefore make specific analyses that allow the understanding of cost and result, customer by customer, channel by channel.
For example: a very common activity of the commercial team is “Meet with Customers”. The cost of this activity is the sum of the commercial area’s efforts (salaries plus salespeople’s benefits and the whole area) including the support areas such as HR (that last month hired 2 new salespeople), the IT area (that this month gave 5 supports related to the new HR system) and also the value of the internal support systems (such as CRM itself); that said, now it’s time to allocate these costs of Meeting with clients – which are not necessarily Product and Service related costs but rather Client related costs (as a periodic maintenance and follow-up activity for these clients); this allocation should be done using the criteria “number of meetings with clients” (assuming that these meetings have an average time approximately equal to each other) or ” meeting hours” if this value varies a lot.
Of course, this allocation must be done taking into consideration the materiality of what is being allocated (that is, many times the effort in collecting and applying this information is not worth it, given the small costs of this activity compared to the other activities of the company) but in many cases it is very well worth it!
This done we have the cost of each customer only with the activity “Meet with Customers” – if we do that with all the activities of the Commercial and Customer Service areas, we will have an interesting suggestion of efforts to be analyzed and surely many surprises will appear, with activities that we never imagined would be so expensive and that would influence so much the costs of each Customer and Channel, and even others that we thought would be expensive, but that in the end turned out to be not very significant.
The set of mapped activities, on one hand their interconnections with the chart of accounts, cost centers, and areas, and on the other hand with the various Products, Services, Clients, and Channels, is called a cost model – and this modeling, if well executed with method and process, allows a vision never before seen in organization!
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It is possible to see the great influence of technology in human relationships and activities over the years. And in the business field, this is no different.
With the innovation of the processes involved in the management and production of an enterprise, it is clear that corporations that do not keep up with this development end up missing out on great opportunities, which may even lead to the business’s stagnation.
Always aiming to be up to date with the market demand and with new tools that have shown advantages at the present time is what defines a successful company.
Within this topic, we can mention the mobile software as an example of successful innovation. It can be accessed on tablets and smartphones and allows managing costs in the company with greater mobility.
For you to know about the importance of this tool, we have prepared this post with its main benefits. Read on!
The first advantage provided by the use of mobile software is high productivity. This is possible thanks to the ability of these resources to offer greater automation of activities and tasks, in addition to a more effective organization of processes. Thus, the business’s productivity is ensured as the demand of the activities is optimized.
Mobile software also improves communication. With this technology, it is possible to send instant notifications in a shorter time to all technicians or production teams in the company.
In practice, having a mobile application prevents professionals from having to move around to pass on information or make any changes to certain processes. Furthermore, this advantage also ensures that the company reduces interpretation errors, as all data is stored in the software.
By using mobile software, it is also possible to direct, in a simple and practical way, the role of each professional in the company and the tasks and goals to be fulfilled.
All production and performance data is stored in the system, which encourages employees to be more committed to their work. Thus, this type of tool improves engagement and promotes the effective participation of the entire team.
Finally, a great advantage achieved by the system is the greater reliability of data and information. That is because, by recording the condition of the work carried out – as well as variables, production numbers and other content related to the company –, there is greater security in data processing.
This helps to eliminate various problems, such as misinformation and poor accuracy when reporting on the progress of the institution’s internal processes.
These are the main advantages guaranteed by mobile software. You can see how this tool can provide countless benefits for your company, can’t you?
That is why it is very important to look for partners that have quality solutions that are compatible with your needs. This is the case of My ABCM, which offers MyABCM Corporate, a software capable of carrying out important functions in your business and that provides several benefits.
Did you like the article and want to know more about our services? Then contact us and talk to one of our consultants!
In a competitive market, many companies need to invest in competitive advantages in order to increase profitability and improve efficiency. (more…)
The commercial sector is not the only one that faces challenges when it comes to increasing profitability. (more…)
Choosing cost management software is an important investment for any company given the various advantages that access to this technology can provide to your organization, such as better information access and analysis.
However, you need to devote some time to deciding which company is best prepared to meet your needs. Should you try a spreadsheet implementation? Should you customize an ERP? Can BI help you tackle this? In this post we’ll suggest a few questions that businessmen should ask before choosing cost management software.
Implementing a Cost Management and Profitability solution requires full-time dedication to this subject. The supplier should be a company that’s 100% dedicated to dealing with all the individual complexity that an implementation of this type requires. All of the services should be executed by the company’s own team and not by partners who may not have the necessary commitment to a successful implementation.
The company should also have proven international experience in specific cost management and profitability projects with companies of all shapes and sizes – which benefits interested buyers because implementation time should thus be diminished at the same time as the quality of the modeling should be enhanced.
Here it’s important to know the business consulting companies that create the conceptual modeling for these solutions. These companies possess valuable know-how in terms of international best practices for the implementation of cost models ranging from the most simple to the most complex and won’t risk recommending a solution that’s not the best.
The solution should have received a positive evaluation from a formal market publication published by a renowned institution (Gartner, IDC…), a Big 4 Consulting Firm (Deloitte, KPMG, PwC and EY), Accenture or a large independent consulting firm.
The solution should be installable in local environments like notebooks that facilitate the prototyping of cost models in an independent manner so that they can be later uploaded to a production environment or scalable hardware with very sophisticated infrastructure. It obviously should also be possible to run it on a 100% web environment with absolutely no local installation necessary.
The user should have the autonomy to run the model and manage costs and profitability independently of the suppliers; the solution should contain specific functionality for this, facilitating the modeling, analysis and the execution of basic and advanced business simulations – all of this with adequate data security, data access levels and performance.
The solution should permit quick and easy analyses through advanced reports or even dashboards or gauges that can be developed by the user. The more functionality and the better the quality the solution offers, the better your monthly and final work results will be.
No one imagines that it’ll be necessary to type out the account list or do manual work. The data that feeds the cost and profitability model should come from existing systems, whether it’s an ERP, spreadsheets, payroll, BI and/or or any other system responsible for a part of the system’s input data.
The solution should have its own ETL (extract, transform and load) mechanisms that will enable it to transform source table data to a format that the software recognizes, making it even possible to take a critical look at the source table data before importing it. The goal is to gain efficiency and avoid rework.
This is a very common question on the part of managers. Let’s begin with spreadsheets: modeling in Excel can be very simple in principle (and it really is), but it’s natural with the first few times you go through the figures and draw conclusions based on your cost modeling that new needs arise. This isn’t even considering the issue of data security and integrity. According to EY, “it is possible to model using spreadsheets, but only with very simple cost models, and even these simple cost models have severe limitations in terms of extracting data for subsequent management analysis.”
ERPs offer the false impression that “they already contain everything required for a cost model,” but this isn’t true: accounting information, technical specifications, revenues and volumes are just some of the data needed to begin modeling costs and profitability. Various other types of data such as process and activity data, capacity, indicators, details of administrative costs and specific business rules aren’t found within an ERP, meaning that the system will have to be customized to meet the needs of an efficient cost model. And we all know how complicated, expensive and time consuming it is to customize any ERP. The supplier can even argue that “the cost model already is included in the package ‘for free,’ but it will require many customizations and adaptations that will often take more than a year to complete. Even when this occurs the model may rapidly become obsolete because, as we know, organizations are becoming more and more dynamic with new products and services, departments, cost centers, processes, channels, and clients appearing continually and there may eventually even be mergers and acquisitions. Unfortunately many companies still believe that ERPs can handle this and continue using compromised modeling which no longer reflects neither what’s present in the ERP nor the reality of the company’s operations.
Trying to accomplish costing within a BI is another innocuous challenge. Professor Bala Balachandran of Kellogg always says that “these systems make it possible to extract extremely wrong data in a simple manner.” A BI will always present data that already exists within an organization. It doesn’t transform data or take into consideration the demands of modeling such as reciprocal cost assignments, the prevention of double counting and the understanding of received costs and costs themselves. Modeling basically represents the effort made in transforming data for subsequent presentation/analysis, not the opposite!
Try to find out if other clients are satisfied with the service provided. Never wait until some unforeseen event occurs to find out if the company’s customer service meets your needs.
As we’ve seen in this article, there are many doubts that arise when you’re thinking of acquiring cost management software. If you’re interested in this technology, get in touch with us! It will be our pleasure to clear up any of your doubts!
Every entrepreneur seeks to earn money when opening a business. This is obvious. The terms profitability and rate of return and often considered synonymous by entrepreneurs and businessmen. But are they really? The answer is no.
It’s essential that the financial and management areas of a firm have a perfect understanding of the difference between these two concepts so that the entrepreneur will be better able to manage the business.
It’s important to understand that these two concepts mean different things. If you want to learn more about this subject, then continue reading this text and eliminate your doubts once and for all!
A company’s profitability, as the name suggests, has to do with its profit. Or in other words, a venture is considered to be profitable depending on the relationship between its net profit and total revenues.
The basic formula for calculating the profitability of a company is as follows:
Profitability = Net Profit x 100 ÷ Total Revenues
Remember that the net profit is the total profit of a company after you deduct expenses, and total revenues are the total amount of money that the business receives. Profitability is an indicator of operational efficiency, whose result is given in the form of a percentage.
The rate of return, on the other hand, is a business’s capacity to generate revenue. Unlike profit, which deals with the revenue that the business has already generated, this indicator refers to investments in products. In other words, it deals with the capacity of a business to generate profit by investing in a given product.
Thus to discover a product’s rate of return, you need to analyze its previous sales. If the investment in it is less than the revenues from its sales, then it’s considered to have a positive rate of return. And for a venture to have a positive rate of return, it has to have greater revenues than its total fixed costs and other expenses.
This indicator is also given in terms of a percentage. The way to calculate the rate of return of a venture is as follows:
Rate of Return = Net Profit x 100 ÷ Investment
The main problem with the confusion between these two concepts, however, is the fact that profitability and a positive rate of return don’t necessarily go together. Profitable companies don’t always have a positive rate of return and vice-versa.
For example: many people think that a large number of sales automatically implies that the merchandise in question is profitable and has a positive rate of return. And this is a mistake: even though the product may have a positive rate of return, given that it doesn’t spend much time in storage, it won’t necessarily be profitable.
This is because profit takes into account the price of the product. In this case, if the price is below the market price, it’s natural that it will have greater sales than the competitors’ products. However, if this price is well below the ideal price, in contrast to the business expenses, it won’t generate profit for the company. The product will have a positive rate of return, but won’t be profitable.
After reading this, you can see how unquestionably important it is to consider both the profitability and rate of return of your company in order to know where and how to invest. Focusing on just one of these aspects may be fatal to your firm’s budget, and confusing these two concepts may hide serious problems with your business.
Understanding how to calculate the rate of return and profitability of a business is critical for managers to clearly visualize the company’s financial situation. Managers commonly confuse these two terminologies, but they represent distinct aspects of the company. You need to know how to increase both if you want to ensure your business success.
If you have any questions about this subject, keep reading this publication. We will explain the concepts of these terms, their importance to the company, how to calculate them, and finally, which techniques are most effective in applying them. Check it out!
What is the difference between the two concepts?
First, it is important to understand that both are indexes that relate to the company’s net income. For this reason, they are constantly confused.
However, the result shows gains from different perspectives. Check out below what each of these concepts aims to achieve.
Rate of return
Rate of return is a percentage value that relates an initial investment and the speed at which a business gets its financial return.
Thus, if the rate of return is low, it means that the project invested is dispensable for the company; if its value is negative, it is causing losses, and finally, if its number is high, it is very beneficial to the company’s finances.
Profitability
This measure, also given as a percentage, shows how much a business effectively received in relation to the overall enterprise’s gains.
While the rate of return shows the return on investment, profitability shows all that has been achieved, taking into account projects, savings, sales, revenues, and other elements of the enterprise.
How important is it to understand the difference between the concepts?
Evaluating just one of these aspects will bring a poor overview of the business, giving a false impression that it is successful. That way, the controller will not have actual data on the enterprise’s gains, resulting in losses and even bankruptcy.
For example, it is possible that you have high profitability, but due to factors other than an investment. That way, you will not know if the project is profitable or not; it may be causing losses that you don’t know about, and that is a waste of capital.
Knowing how to calculate these indexes ensures the correct profit determination. This has a positive impact on the enterprise’s decision-making, since they will effectively provide the healthy growth of the company.
How to calculate rate of return and profitability?
Rate of return
Rate of return considers time as a fundamental variable. Usually it is calculated by relating the month and its corresponding cash flow. Another variable involved is the initial investment, and the formula is given as follows:
Rate of return = (net income in the period / initial investment) x 100%
Thus, let’s consider a business that required an initial investment of $400 million. Currently its monthly cash flow is about $25 million. In this instance, the monthly rate of return is given by:
Rate of return = (25/400) x 100%
Rate of return = 6.25%
A business is not profitable when this index is null or negative, which indicates that the investment has led to losses. On the other hand, the higher a business’s rate of return, the faster there will be a return on investment.
Profitability
In turn, to find a business’s profitability, you need to think in terms of turnover and net income for the period being analyzed. The relation is given by:
Profitability = (net income / total turnover) x 100%
Imagine, for example, that in one year a company had a turnover of $500 million. The gross income was $300 million and the net income $200 million. In this instance, the profitability would be:
Profitability = (200 / 500) x 100%
Profitability = 40%
This means that profitability depends much more on net income than on turnover, given that a very high turnover associated with low income lowers this index.
To better understand it, imagine the same situation, but in this case the income was just $100 million. Profitability would decrease to a half, even though the turnover remains the same.
How do you increase these indexes?
It is possible to act on these indexes so that they are increased or are more in keeping with management’s expectations.
Increasing profitability
These measures consist of making new investments whose returns can be measured. Here are some examples.
Segment the audience
Customers are the focus of any business, given that the revenue to sustain it comes from them. Markets are currently very crowded. In order to ensure that a particular audience will always acquire your brand’s products, you can develop goods and prepare a marketing action for a very specific consumer profile.
Create techniques to increase productivity
There is always room for maximizing employee productivity, whether by changing materials, exchanging staff, automating process, among other methods.
Negotiate prices with suppliers
Good negotiation can be exceptionally beneficial to the company. If you have a good relationship with a trusted supplier, try to negotiate lower prices with them. For example, you can offer a loyalty scheme to always acquire your raw material with them in exchange for a reduced price.
Maximizing profitability
Here we will show the main methodologies that increase the overall net income of the company; check it out.
Reduce operating costs
This strategy increases both the rate of return and profitability. Operating costs are those needed to keep the enterprise active, such as wages, electricity, etc. Reducing these expenses will result in an increase in the company’s profitability, not an increase in revenue.
Implement continuous improvements
There are numerous strategies and technologies that can be applied in the company: the biggest mistake a manager can make is to not continually seek improvements. These can be a better structural organization, computerization of the enterprise, use of new indexes that aid in decision-making, etc.
By using financial software, processes become faster, simpler and more accurate. With less time lost, there is more productivity, leading to gains in both rate of return and profitability.
Review sales prices
Customers’ taste, product values, and tax rates go through constant changes. Thus, the price of your goods or services should also be updated to keep up with the market.
Depending on the scenario, your products’ values could be higher, which would generate more profits, but it would also be feasible to reduce your prices in order to expand your customer network. This study will maximize profitability.
You can see that understanding how to calculate the rate of return and profitability allows you to have a real and transparent view of the business, and also ensures a more accurate and concrete decision-making. After reading this publication, you will know exactly how to use this knowledge to foster the company’s growth.
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