3.5.2 Strategies to Improve Profitability Ratios Notes

Strategies to Improve Profitability Ratios

1. Profitability ratios measure how effectively a business generates profit relative to sales, costs, or capital employed.
2. The three key ratios are:
   1. Gross Profit Margin
   2. Profit Margin
   3. Return on Capital Employed (ROCE).

Gross Profit Margin

1. Gross Profit Margin measures the percentage of revenue that remains after deducting the cost of goods sold (COGS).
2. It indicates how efficiently a business produces or sources its products.

$$\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100$$

Strategies to Improve Gross Profit Margin

1. Reduce COGS: By purchasing from cheaper supplier, COGS can be reduced.
2. Bulk Purchasing: Buying in larger quantities often leads to discounts from suppliers.
3. Supplier Negotiations: Renegotiate contracts to secure better terms or lower prices.
4. Efficiency Improvements: Streamline production processes to reduce waste and lower costs.
5. Increase Prices: If the goods have lesser substitutes, increasing the prices may increase gross profit.
6. Value Proposition: Justify higher prices by highlighting unique features or benefits.
7. Targeted Pricing: Increase prices selectively for products with inelastic demand.

Profit Margin

1. Profit Margin measures the percentage of revenue that remains as profit after all operating expenses are deducted.
2. It provides a broader view of a company's profitability.

$$\text{Profit Margin} = \frac{\text{Profit before Interest and Tax}}{\text{Revenue}} \times 100$$

Strategies to Improve Profit Margin

1. Cut Operational Expenses: Reducing costs associated with running a business by optimizing resources, improving efficiency, and eliminating unnecessary expenses.
2. Outsourcing: Contract non-core activities to specialized firms to reduce costs.
3. Automation: Invest in technology to streamline operations and reduce labor costs.
4. Increase Sales Volume: Boosting the quantity of products or services sold through targeted marketing, enhanced customer engagement, and expanding market reach.
5. Marketing Campaigns: Invest in targeted advertising to boost sales.
6. Product Diversification: Introduce new products or services to attract more customers.

Return on Capital Employed (ROCE)

1. ROCE measures how efficiently a business uses its capital to generate profit.
2. It's a key indicator of overall financial performance.

$$\text{ROCE} = \frac{\text{Profit before Interest and Tax}}{\text{Capital Employed}} \times 100$$

Strategies to Improve ROCE

1. Optimise Asset Utilisation: Maximizing the efficiency of assets by ensuring they are used to their full potential, reducing downtime, and improving productivity.
2. Increase Efficiency: Use assets more effectively, such as improving factory output or reducing downtime.
3. Asset Sharing: Share underutilized assets with other businesses to generate additional income.
4. Reduce Capital Employed: Minimising the amount of capital invested in business operations by improving asset efficiency and reducing unnecessary investments.
5. Sell Underperforming Assets: Dispose of assets that do not contribute significantly to profits.
6. Lease Instead of Buy: Consider leasing equipment to reduce long-term capital commitments.

Balancing Strategies and Risks

1. While improving profitability ratios is essential, businesses must consider potential risks:
   1. Quality vs. Cost: Reducing costs should not compromise product quality or customer satisfaction.
   2. Price Sensitivity: Increasing prices may lead to a loss of customers if demand is elastic.
   3. Long-Term Impact: Cutting expenses in areas like marketing or R&D can harm future growth.