Profitability and Cost Structure Analysis: External Data Analysis Frameworks

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Management Consulting Training
Profitability and Cost Structure Analysis:
External Data Analysis
Frameworks ROCE
Operating Profit
Capital Employed
Gross Profit
Sales (Turnover)
Operating Expenses
Sales (Turnover)
Sales (Turnover)
Fixed Assets
Sales (Turnover)
Working Capital
Profit Margin Asset Turnover
Sales (Turnover)
Capital Employed
Operating Profit
Sales (Turnover)

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Contents
Cost Management Overview
Profitability Analysis
Cost Structure Analysis
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3

Profitability and cost structure analysis provides many invaluable
insights—there are numerous frameworks to conduct these analyses
Presentation Overview
Profitability and cost structure analysis provides many invaluable insights.
Obvious examples include identifying profitable products and projects and
identifying key cost driving activities and resources—which lead to better
strategic decisions.
There are a number of business frameworks to conduct profitability and cost
structure analysis. In this consulting training series, we will 4 common
frameworks split into 2 categories:
External Data Analysis
Internal Data Analysis
This deck will focus on External Data Analysis only.
It also includes an overview to Profitability and Cost Structure Analysis.
3

Profitability and cost analysis are clearly linked—the level of analysis will
depend on access to financial information
Profit Formula
If we had perfect information, we could calculate the individual profitability of every item
sold to every customer through every channel.
Profit = Revenue - Cost
How you define ‘costs’ will define which profitability you are measuring:
– E.g. Gross profit is turnover less costs of good sold
The accuracy with which you can measure or estimate revenues and costs will
define how insightful your analysis can be:
– Often we only have access to publicly available information, which is presented at the Group
level in broad categories
– With internal data or management information, we can do much more meaningful and insightful
analysis
3

With access to internal information, we can conduct a much greater range
of analysis
General Ledger Overview
Information held on General Ledger systems—this is the system that track
revenue and costs at the most detailed level within the company:
– “Journal entries” are posted to the general ledger
The General Ledger is usually broken down by department and by cost/revenue
type
Examples of cost types:
– Revenues from individual customers, rebates, trade discounts, etc
– Salary, pension, national insurance costs
– Utility costs
– Building rental / insurance / maintenance
– Consumables / Stationary
– Raw material costs, etc.
The financial accounts (including Profit and Loss statement) are built up from this system.
3

Our usual starting point for profitability analysis is the annual profit and
loss statement
Typical Profit and Loss Account Structure
FOCUS OF OUR
ANALYSIS
Turnover
- Cost of Sales
Gross Profit
- Distribution Costs
- Administrative Expenses
Operating Profit
+ Other operating income
Operating Profit including share of joint ventures and associates
+ Profit on disposal of businesses
Profit on ordinary activities before interest
- Interest Payable
- Tax Payable
Profit on ordinary activities after tax
+ Minority Interests
+/- Extraordinary items
Profit for financial year
3

The type of analytics we can do will depend on the available sources
of our data
Data Sources
Lack of data should not constrain us from being creative—we can usually apply all of these
frameworks with limited data to identify meaningful insights.
Internal DataExternal Data
Data Sources:
− Annual Reports
− Brokers Reports
− Industry Journals / Studies
Type of Analyses:
− Profitability
− Cost Structure
Data sources:
− Company management accounts
− General Ledger
Type of Analyses:
− Cost Drivers
− Activity Based Management
3

Contents
3

Market value is influenced by both financial & non-financial performance &
the recognition of intangible value drivers
Introduction to Profitability Analysis
OVERVIEW & INSIGHTS
This is an analysis of company’s or business
unit’s profitability
Can use various ratios to examine underlying
profitability:
− Profit Margins
− ROCE
Complete graphical outputs to review relative
profitability:
− Over time
− Between units
Can also form the basis of economic models to
forecast future performance and value
It helps us understand how well companies are
performing
Establish consistent comparisons between
companies, identifying further areas for study
STRENGTHS
Allows high level identification of
performance
Quickly allows identification of areas
of further investigation
LIMITATIONS
Limited real insight into underlying
issues—only starting point for real
analysis
3

Profitability Analysis – Illustrative Output
Regus’ EBIT, 1997-2000, vs. HQ’s EBIT, 1999-2000a (£m)
-4.6
-15.2
-43
12.412.4
26.2
-50
-25
0
25
50
75
1997 1998 1999 2000
HQ
Regus
Source: Regus’ Annual Report, 2000; David O’Neill, “Frontline Capital Group”, William Blair & Company, 14/1200; www.regus.com, 20/09/01.
a. Converted from $ using average 1999 rate £1 = $1.6164, average 2000 rate £1 = £1.5258 (International Financial Statistics, IMF, January 2001, 2000 =
estimated).
b. Revenue divided by number of business centres at end 2000 (HQ = 470, Regus = 335).
3

Source: Aer Lingus Group Annual Reports and Accounts; British Airways Annual Reports and Accounts; FAME.
Operating Margin, %
3.5
6.3
2.4
1.8
-4.2
5.5
3.4
5.6
7.1 8.6
9.4
6.5
0.8
0.5
-0.4
0.3
1.6
-5
0
5
10
1991 1992 1993 1994 1995 1996
Aer Lingus
British Airways
British Midland
3

Note: Exceptional items in 1993 amount to over IR£136m including provisions for restructuring and the revaluation of GPA shares.
Source: Aer Lingus Group Annual Reports and Accounts, 1991-1996; 1993 figures as restated; 1994 figures scaled to compensate for 21 month accounting
period.
Group Profit (IR£m)
38.6
27.4
15.7
-34.2
19.9
49.8
41.8
27.6
8.3
-11.8
-191.1
-74.2
15.0
32.0
-200
-150
-100
-50
0
50
1990 1991 1992 1993 1994 1995 1996
Operating Profit
Profit after Tax and
Exceptional Items
3

Source: Aer Lingus Group Annual Reports and Accounts, 1991-1996; 1993 figures not restated; 1994 figures scaled to compensate for 21 month
accounting period.
Operating Profit by Division (IR£m)
-16.8 -16.2
-22.9
36.6
43.6 42.2
44.2
31.8
23.7
4.1
-3.4
-0.4
0.8
27.4
15.7
41.8
40.240.6
-30
-20
-10
0
10
20
30
40
50
1991 1992 1993 1994 1995 1996
Air Transport
Airline Services and Other
Total Operating Profit
3

Return on capital employed (ROCE) is a key measure of a company’s
underlying performance
ROCE Formula
Note: Capital employed is usually taken at year end, as this reflects conservative view; it may be taken as average of capital employed at beginning and
end of year—analyst discretion is need;
Note: Telenor define ROCE as (PBT + financial expenses)/Average (total assets – non-interest bearing debt)
a. Source: “The Meaning of Company Accounts”, Reid and Myddelton, 1992.
b. Clear definitions are required for what items are included or excluded; consistency is paramount.
Return on
Capital
Employed
(ROCE)
=
Operating Profit (PBIT)
Capital Employed (Net Operating Assets)
DEFINITION / FORMULAa
Where…
• Operating Profit (PBIT) = Gross Profit – Operating Expenses
• Capital Employed (Net Operating Assets) = Fixed Assets + Net Working Capital
Return on capital employed (ROCE) is also known as return on net (operating) assets
(RONA)b.
3

Measuring ROCE can also provide key insight for many management
decisions
ROCE Overview
However, there are lots of alternative measures of profitability—Return on Equity (ROE),
Risk adjusted Return on Capital (RAROC), etc.
ROCE is an important measure of profitability:
− Reflects return to all stakeholders investing capital in company.
− A low return on capital employed can easily be wiped out in a downturn.
− ROCE serves as a guide to potential investment or acquisition:
If potential ROCE isn’t attractive, investment/acquisition should be avoided.
− A consistently low ROCE for any division/business unit suggests it could be
a candidate for disposal if not part of core business.
3

Breaking ROCE to its constituent ratios allows us to focus on real drivers
of performance
ROCE Ratios
ROCE
Operating Profit
Capital Employed
Gross Profit
Sales (Turnover)
Operating Expenses
Sales (Turnover)
• Materials
• Labour
• Overheads
• R&D
• Distribution
• Administration
Sales (Turnover)
Fixed Assets
Sales (Turnover)
Working Capital
• Land and buildings
• Plant machinery
• Stocks
• Debtors
• Cash
• Trade creditors
Profit Margin Asset Turnover
Sales (Turnover)
Capital Employed
Operating Profit
Sales (Turnover)
3

Source: Aer Lingus Group Annual Reports and Accounts; British Airways Annual Reports and Accounts; FAME.
Return on Capital Employed, %
2.4
5.4
2.0
1.3
-3.3
5.0
6.2
6.9 7.0
9.2
10.1
7.5
8.9
4.8
-3.0
1.1
8.4
-5
0
5
10
1991 1992 1993 1994 1995 1996
Aer Lingus
British Airways
British Midland
3

The type of analytics we can do will depend on the available sources
of our data
Tips
Hints and PitfallsPotential Insights
Long-term trends in company
performance
Outcomes of strategic decisions—
pursuing low cost strategies, moving
up-scale
Intra-company comparisons
Compare like with like:
− Adjust data to ensure consistency of
definitions—profitability, capital
employed, etc.
Complete analysis on a spreadsheet—
it will save time later and will ensure
error free calculations
Beware exceptional items—understand
what they are for and make judgments
as to their materiality
3

Contents
3

Cost Structure Analysis is a way to intuitively visualize a company’s cost
structure—and the relative magnitudes of the cost components/drivers
Introduction to Cost Structure Analysis
OVERVIEW & INSIGHTS
This framework graphically presents a
company’s cost structure
Builds cost bars taking account of:
The various components of the cost structure
The importance (relative or in absolute terms)
of the components in the cost structure
Understand where revenues, costs and profits
are incurred
Establish comparisons between cost structures
for:
− A product/business over time
− A product/business in each of several
companies
− Several product lines in the same company for
one time period
STRENGTHS
Allows a quick appreciation of trends
and differences.
Provides a homogeneous basis for
comparison.
LIMITATIONS
None
3

Cost Structure for
One Product over
Time
Cost Structure Analysis – Illustrative Output
0
20
40
60
80
100
1977 1979 1981 1983
0
20
40
60
80
100
Company
A
Company
B
Client Company
C
0
20
40
60
80
100
120
Product
A
Product
B
Product
C
Product
D
Materials
Advertising
Sales
R&D
Annual sales ($mm)
Percentage of total sales
100
19
120
22
150
28
170
31
Cost components as percent of sales
Current
Dollars
Current
Dollars
Current
Dollars
Cost Structures
for Same Product in
Different Companies
Cost Structure for
Different Products in
One Company
3

Cost Structure Analysis – Illustrative Output
Cost Categories as a Percentage of Sales, 1996 - 2000 (%)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1996 1997 1998 1999 2000
Operating Margin
Administrative Costs
Distribution
Selling Costs
Cost of Goods Sold
3

When comparing different cost structures and drawing insights,
make sure you are comparing “apples to apples”
Tips
Hints and PitfallsPotential Insights
Assesses cost drivers:
− Helps identify which cost components
have increased or decreased the most
− Triggers questions for further research
and analysis
Identifies potential areas for value
differentiation
Do:
− Make sure you use correct measures of a
company’s costs (especially with costs
shared among products or business units)
− Check accuracy of competitors’ data
− Consider pure play benchmarks from other
markets if competitor example not
available
Don’t:
− Compare competing products that are not
truly comparable
3

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1
Flevy (www.flevy.com) is the marketplace
for premium documents. These
documents can range from Business
Frameworks to Financial Models to
PowerPoint Templates.
Flevy was founded under the principle that
companies waste a lot of time and money
recreating the same foundational business
documents. Our vision is for Flevy to
become a comprehensive knowledge base
of business documents. All organizations,
from startups to large enterprises, can use
Flevy— whether it's to jumpstart projects, to
find reference or comparison materials, or
just to learn.
Contact Us
Please contact us with any questions you may have
about our company.
• General Inquiries
support@flevy.com
• Media/PR
press@flevy.com
• Billing
billing@flevy.com

Profitability and Cost Structure Analysis: External Data Analysis Frameworks

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Profitability and Cost Structure Analysis: External Data Analysis Frameworks