Business

How a Firm Should Determine Profitability

This post is authored by Bushra Farooq, in Supply Chain Hubspot Magazine

Profitability

As the world is developing day by day, firms are getting more competitive to win the race of satisfaction and maintenance of good relationship with customers, by providing them excellent quality of goods and services in the minimum price and accurate time. To meet the rising demand of customers and to the firm’s goal, a firm should know how to determine the profitability.

The following factors will help in determining the profitability of the firm.

1) The degree of competition a firm faces: It is very important for a firm to be aware what their competitors are doing. If the market is very competitive then profit will be lower. This is because consumers would only buy from the cheapest firms. Market contestability is how easy it is for new firms to enter the market. If entry is easy then firms will always face the threat of competition; even if it is just “hit and run competition” – this will reduce profits.

2) The strength of demand: As we are observing rapid fluctuation in consumer’s tastes and need, a firm should know the needs of consumer are and what they want. For example demand will be high if the product is fashionable, e.g. mobile phone companies were profitable during the period of rising demand and growth in the market. Products which have falling demand like Spam (tinned meat) will lead to low profit for the company. Some companies like Apple have successfully carved out strong brand loyalty making customers demand many of the new Apple products.

However in recent years profits for mobile phone companies have fallen because the high profit encouraged over supply, negating the increase in demand.

3) The state of the economy: If there is economic growth then there will be increased demand for most products especially luxury products with a high income elasticity of demand. For example manufacturers of luxury sports cars will benefit from economic growth but will suffer in times of recession.

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4) Advertising: A successful advertising campaign can increase demand and make the product more inelastic demand; however the increased revenue will need to cover the costs of the advertising. Sometimes the best methods are word of mouth. For example, it was not necessary for YouTube to do much advertising.

5) Substitutes: If there are many substitutes or substitutes are expensive then demand for the product will be higher. Similarly complementary goods will be important for the profits of a company.

6) Relative costs: An increase in costs will decrease profits. This could include labour costs, raw material costs and cost of rent. For example a devaluation of the exchange rate would increase cost of imports therefore companies who imported raw materials would face an increase in costs. Alternatively if the firm is able to increase productivity by improving technology then profits should increase. If a firm imports raw materials the exchange rate will be important. Any depreciation will make imports more expensive. However depreciation of the exchange rate is good for exporters who will become more competitive.

7) Economies of scale: A firm with high fixed costs will need to produce a lot to benefit from economies of scale and produce on the minimum efficient scale, otherwise average costs will be too high. For example in the steel industry we have seen a lot of rationalization where medium sized firms have lost their competitiveness and had to merge with others.

8) Dynamically efficient: If a firm is not dynamically efficient then over time costs will increase. For example, state monopolies often had little incentive to cut costs, e.g. get rid of surplus labor. Therefore before privatization they made little profit. However with the workings and incentives of the market they became more efficient.

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9) Price discrimination: If the firm can price discriminate it will be more efficient. This involves charging different prices for the same good. So the firm can charge higher prices to those with inelastic demand. This is important for airline firms.

10) Management: Successful management is important for the long-term growth and profitability of firms. For example, poor management can lead to decline in worker morale, which harms customer service and worker turnover. Also firms may suffer from taking wrong expansion plans. For example, many banks took out risky sub-prime mortgages, but this led to large losses. Tesco suffered from expanding into unrelated business, like garden center. This led to over-stretching the company and losing site of core-business.

11) Objectives of firms: Not all firms are profit maximizing. Some firms may seek to increase market share, in which case profits will be sacrificed to gain market share. For example, this is the strategy of Walmart and to an extent Amazon.

Conclusion:

The acumen for writing this is to acknowledge firms how to be profitable in this challenging environment. Firms can take advantage from the factors mentioned above by working on them and to consider these factors for the progress and profit.


Disclosure: This is a curated column. The statements, opinions and data contained in these publications are solely those of the individual authors and contributors and not of iamwire or its editor(s). The article was originally published by the author here.

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