Profitability analysis is at the heart of the financial analysis process. It aims to explain the value creation of the company. It also follows the analysis of activity (changes in sales). Finally, it precedes that of the financial balance of the balance sheet and the debt. Analyzing profitability involves identifying scissor effects and absorption of fixed costs.
Profitability: The Problem
If turnover increases by 10% and the result increases in different proportions, there is a phenomenon that needs to be explained. Profitability analysis essentially consists of detecting two major causes of variation in the result, the scissor effect and the absorption effect of fixed costs.
What Is The Scissor Effect?
It refers to a favourable or unfavourable change in the selling price in relation to the cost of purchasing goods sold for a distributor or the consumption of raw materials for an industrialist. The scissor effect is detected by changes in the commercial or gross margin (table of intermediate management balances) expressed as a percentage of sales.
A favourable scissor effect can come from:
- better negotiation of purchase prices, for example due to an increase in volumes purchased;
- improved “product mix” with higher-margin products being better sold;
- favourable exchange rate effect, import or export.
An adverse scissor effect may result from:
- inability to pass on the rising cost of purchasing raw materials into the selling price;
- a more aggressive trade policy of market share or a defensive response to increased competition.
For an industrialist, a scissor effect may also result from a change in the rate of loss on raw materials (brake) in the production process. The scissor effect may also result from a change in transportation costs. Thus, a supplier of low-priced weight products (cement, cartons, water, etc.) will have an adverse scissor effect by delivering geographically more distant customers.
The income statement only tracks gross financial data (sales and consumption). Therefore, its reading alone does not identify the origin of the scissor effect (variation in the selling price or the cost of purchase). Only the knowledge of the context of the company will allow us to know its origin.
For a distributor, the analysis of the commercial margin rate is often of crucial importance. Suppliers who conduct financial analysis of members of their distribution network often identify the minimum commercial margin rate. Below this rate, their client cannot materially cover his structural expenses and make a profit.
The “Absorption Of Fixed Costs” Effect
To analyze profitability, it is essential to look at the absorption effect of fixed costs. In the case of increased sales, fixed or rather fixed-dominant expenses change in stages. This will allow the company to absorb an increase in its business. This includes a constant workforce, the same space area and the same level of equipment up to a certain point. After a threshold, it will be forced to hire, expand, invest.
The detection of the absorption effect of fixed charges, favorable or unfavourable, consists of analysing the evolution of “fixed-dominant” operating expense items. They are expressed as a percentage of sales. For the profit account of a company in French standards, these are other purchases and external expenses, personnel expenses and depreciation and amortization.
An absorption effect of favourable fixed costs results from:
- Increased sales at a higher rate than the expense item;
- decrease in the cost position at a faster rate than sales
The impact of the presentation of the income statement
There are two main methods of presenting the income statement:
- Expenses are presented by type
- They are grouped by function (production, commercial, administrative, R&D).
The Two distinct presentations
Calculating a specific profitability rate requires a certain method of presentation. De facto, the interest of presentation by nature is to be able to spot a scissor effect in its purest form. This effect is detected by the analysis of changes in the commercial margin or gross margin rate. Apart from the change in the loss rate on raw materials, the gross or commercial margin rate varies only according to a change in selling price or cost of purchase.
Conversely, in the result count by function, the scissor and absorption effects of fixed loads are less apparent. The gross margin is calculated net of the cost of production of the products or services sold. Thus, for an industrial enterprise, an unfavourable scissor effect due to the increase in the cost of raw materials can be compensated by better absorption of fixed production costs. The latter is itself due to productivity investments or an increase in activity.