In order for a business to remain in place, it must turn a profit at some point. In order to earn a profit in any given year, it must make good decisions when it comes to making changes to its business, products it sells, or enhancing additional product lines. Whenever a new project comes about, completing a profitability analysis would be very beneficial.
This article will discuss what a profitability analysis is, how a business can use it to optimize their business, and how it could be used to analyze the business as a whole.
What Is the Profitability Analysis?
Profitability analysis is a part of overall business planning in which a business owner or financial analysis will try to forecast the profitability of a new business venture. A profitability analysis could be complete on a wide range of different ventures. This includes:
- Expansion of an existing product line;
- Implementation of a new one;
- Purchase or an entirely new business.
At the end, the business owner should be able to determine whether the new venture has a high likelihood of success and turning a profit.
How to Complete a Profitability Analysis? 5 Areas to Cover
When you are looking to complete a profitability analysis, you will need to be able to complete high-level projections about how the new venture will produce financially and how it will impact your business as a whole.
- The first thing that you need to think about is what revenue will be. For example, if you are looking to sell a new product or service, you will need to complete market research to determine what a fair sales price will be.
- You will then also have to estimate volume to determine what the gross potential sales could be. Ideally, you should sensitize the sales number in the event your sales are not as high as expected or if your collections lag.
Another part of the profitability analysis will be to focus on what the expenses will come along with the new product. The first expense to consider is what the cost of inventory and cost of goods sold will be.
By doing some research with existing vendors, you could figure out what you will pay for materials and supplies necessary to build the new product.
3. Overhead Costs
A profitability analysis will also have to incorporate other overhead expense estimates. If you are expanding your product line, you will likely need to:
- Hire more people;
- Rent out a larger space for production;
- Incur more production and utility costs;
- Even borrow more money from the bank to facilitation the expansion and inventor purchases.
You need to carefully consider all of these costs. Then, include them your overall analysis.
While it is important to consider the profitability of the new venture, you also need to factor in whether expansion will benefit the rest of your business.
For example, if you are going to be using many of the same suppliers, you may have more purchasing power. This could reduce your inventory costs for all products that you produce.
5. Result Analysis
The end result of the analysis should provide you with:
- An estimate of how profitable the new venture will be;
- How the new venture will affect the rest of your business.
This should help you to better analyze the new venture and make a better business decision.
Advantages of a Profitability Analysis
When you are completing a profitability analysis there are many advantages that will come.
- The first advantage is that it will provide you with a detailed estimate of how profitable the new venture will be and how it could affect your business for years to come.
- Another advantage of completing a profitability analysis is that it can provide you with an abstract view and analysis of the venture. When you are completing the analysis, you will spend time focusing on a variety of different areas including the market, costs, and potential demand.
- When you go through this process, there is a good chance that you will highlight additional risks that could come with the new venture that you did not think about otherwise.
- You could also identify risks associated with other areas of your business, which you can then address accordingly.
Disadvantages of a Profitability Analysis
There are some advantages that come with completing a profitability analysis. However, there are risks and downsides associated with it as well.
- One of the main risks of completing a profitability analysis is that those that are completing the analysis are often motivated to expand the business. So, they could end up being a bit too aggressive with projections than they should be. Because of this, when you complete a profitability analysis, it may be a good idea to have one completed by an outside consultant. The consultant will be able to look at the plan with a completely objective view. He or she can provide you with a rationalized profitability analysis. Furthermore, if your new plan will require raising more equity or debt, having a third party business plan completed could be a requirement of the new investor or bank.
- Another downside of completing a profitability analysis is that the analysis could be taken as fact instead of predictions. Once a profitability analysis is complete, many people tend to forget that there are a lot of assumptions made in the analysis. This can then make it easy to forget about all of the additional risks that connect to any new expansion.
In conclusion, expanding into a new product line can be a great option for a new business. When looking to expand into a new venture, one great option would be to complete a profitability analysis.
A profitability analysis will be able to provide you with an objective view on how well a new venture could perform. You can also discover how well it could impact the rest of your business and company bottom line.
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