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Profitability of an organisation is dependent upon two factors, namely :
1-Revenue of the organisation
2-Costs of the organisation
Revenue is dependent upon several factors e.g. prices charged and quantity sold or number of times service is provided. Another factor is credit policy of the organisation and discounts offered in this regard. Competition in the industry will also impact the profitability of the organisation as this may reduce the market share of its products or services. Marketing strategy may also have significant impact upon the number of products sold or service provided.
Costs of the organisation may also be dependent upon several factors.
But major determinants of profitability are Revenue and Costs of the relevant business.
Profitability factors determined by several elements:
1. production costs
2. The size of the untapped assets
3. The volume of external financing: through deducting the amount of interest on the loan before the net profit account
These factors will all determine the profitability of firms
1. The degree of competition a firm faces. If a firm has monopoly power then it has little competition, therefore demand will be more inelastic. This enables the firm to increase profits by increasing the price. For example, very profitable firms, such as Google and Microsoft have developed a degree of monopoly power, with limited competition.
However, in theory, government regulation may prevent monopolies abusing their power e.g. the OFT can stop firms colluding (to increase price) Regulators like OFGEM can limit the prices of gas and electricity firms.
2. If the market is very competitive then profit will be lower. This is because consumers would only buy from the cheapest firms. Also important is the idea of contest-ability. Market contest-ability 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.
3. The strength of demand. 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..
4. 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.
5. 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.
6. 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.
7. Relative costs. An increase in costs will decrease profits, this could include labor 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. An depreciation making imports more expensive. However depreciation of the exchange rate is good for exporters who will become more competitive.
8. 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 merger with others.
9. 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.
10. 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.
11. 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 centre. This led to over-stretching the company and losing site of core-business.
12. Objectives of firms. Not all firms are profit maximising. 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.
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