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How to Determine Profitability and Drive Strategic Decisions
- 11 Jun 2020
How can you, as an employee, bring tangible value to your organization? It’s a question professionals across industries grapple with every day. One way is to leverage financial accounting skills to calculate the profitability of your company and projects, and use that knowledge to drive strategic decisions.
Every decision you make impacts your company’s finances, whether you realize it or not. Consider shifting to a top-down mindset—start with an understanding of your organization’s overall financial health, and work downward from there to ask, “What decisions can I make at my level to positively impact my organization’s profitability?” This is strategic decision-making.
Developing a familiarity with your company’s financial statements is a good place to start. To calculate profitability and expected financial returns, you need to be able to read and understand an income statement . To round out your knowledge of your company’s finances, familiarize yourself with the balance sheet and cash flow statement . The elements of these documents are the building blocks for the formulas that determine profitability and, therefore, can act as a springboard for the strategic decisions you make in the future.
By understanding your company’s financial position, you can calculate the predicted profitability of future projects and determine which will be most impactful on your business.
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Using Profitability to Drive Strategic Decisions
With the tools and knowledge to calculate profitability, you can drive strategic decision-making at your organization. Here are three ways to do so.
1. Select Which Projects to Execute
Understanding how to calculate profitability can inform which projects or initiatives you decide to pursue. For instance, if your company’s profit margin is low because of a widespread salary increase, it may not be wise to choose a high-cost project with no proof of a solid return on investment . On the other hand, if your company’s profit margin is high due to recent cost savings from process efficiencies, now could be a good time to select a project with indicators of future profitability.
2. Pitch Projects and Initiatives
If you’re not in a decision-making role, using your organization’s profitability to plan your projects and initiatives can give you leverage when pitching your ideas to executives or team leads. Show that you’ve done the calculations required to understand the full impact your project will have on the company. If your project will increase profitability, you’ll be more likely to earn the funding to execute it.
3. Keep the Bigger Picture in Mind
Some people fall into the trap of “working in the business” instead of “working on the business,” and get bogged down by small details. Understanding the profitability of both your organization and projects can be a reminder that your actions and decisions directly impact your company’s finances.
Related: A Beginner’s Guide to Reading Financial Statements
3 Metrics for Predicting the Profitability of a Project
Understanding how to track and leverage financial data and measures can greatly benefit your business acumen and skills. Here are three metrics you can use to predict the profitability of a project and make more informed decisions.
1. Net Present Value
To calculate what a specific investment is worth to your company today, you need to take the value of the investment over time into consideration.
“The sooner cash inflows are received, the more valuable they are,” explains Harvard Business School Professor V.G. Narayanan in Harvard Business School Online’s Financial Accounting course. “And the longer the cash outflows are delayed, the better.”
To calculate the net present value (NPV) of a project, you need to first determine the present value of each cash flow in the scenario. Any expenses you need to make to complete the project must be accounted for, along with the anticipated inflow of cash from the project’s success.
Present Value = Payment / (1 + Discount Rate) Number of Periods
In the present value equation, the payment is the amount of the predicted cash inflow or outflow (for instance, the amount of cash you expect the project to generate or the amount you’re paying for equipment to do the project).
The discount rate is a percentage rate determined by a company to calculate the present value of future cash flows. The discount rate is determined based on the factors that influence the time value of money, such as inflation, risk, and opportunity cost. Because future cash flows come with a higher degree of uncertainty, they’re worth less than if you received the same amount of cash right now. When using discount rate in the equation, make sure to use its decimal form.
Finally, the number of periods is how often you’ll be paying or receiving that amount of money. Is this a one-time payment, or a monthly subscription? Be sure to account for that.
The net present value is the sum of the present values of each cash flow of your project. Once you have calculated the present values of each cash flow, add them up. If the NPV is a negative number, it means the project isn’t predicted to be profitable and thus isn’t a recommended investment.
2. Internal Rate of Return
The internal rate of return (IRR) is the discount rate that sets the net present value of a project to zero. In other words, your project would be neither profitable nor losing money.
It’s recommended to calculate IRR using Excel, or similar spreadsheet software, due to the complexity of the formula.
In Excel, use the formula “=IRR” and, in parentheses, enclose the cells of the column containing your cash flows (for example, “=IRR(B2:B5)”).
The IRR is the highest acceptable discount rate. It can be useful when weighing which projects to pursue—those with a discount rate higher than the IRR aren’t likely to be worthwhile investments.
3. Payback Period
The payback period is the amount of time it will take to break even on a project. This metric is straightforward and can be useful when pitching projects. Determining the payback period shows your project is predicted to not only be profitable, but bring a return on investment over a certain period.
To calculate the payback period, look at your cash inflows by period in a chart or spreadsheet. Then, subtract each cash inflow from the initial cash outflow to find the cumulative cash flow at the conclusion of each period. There will be a point where your cumulative cash flow flips from being a negative number to a positive one. Your payback period falls between those two periods (for instance, between one and two years).
To determine exactly where the payback period falls, use the following formula:
Payback Period =
Last Period of Time with Negative Cumulative Cash Flow
(Last Negative Cumulative Cash Flow / First Positive Cash Inflow)
It’s important to note that while payback period is a useful metric, it doesn’t consider the time value of money in the same way as the NPV and IRR calculations. For this reason, it’s recommended you use it in tandem with the NPV and IRR formulas to ensure you have the full picture of your project’s predicted profitability.
Determining the Profitability of a Project: An Example
Suppose you work at a bakery and have an idea to purchase a revolutionary piece of baking machinery that will allow you to drastically increase your output of specialty cookies to meet growing demand. Before pitching your idea to the bakery owner, you’d like to determine its potential profitability.
Determining Net Present Value
First, you need to list your cash flows for the project. Let’s say you know you’ll be able to make 2,000 specialty cookies per year with this machine. You’ve also learned from the manufacturer that the next generation of the machine, which will allow even greater production capacity, will come out in three years, and you anticipate upgrading to that model to meet demand. As such, you will only consider three years of use in your analysis.
The cost of the machine is $7,200, which includes shipping and installation.
Your market research reveals that the majority of people would be willing to pay $2 for one of your specialty cookies, and you anticipate selling all 2,000 cookies you plan to produce each year. Your cash flows are as follows:
- Total cost of the machine: -$7,200
- Anticipated revenue for each of the three years: $4,000
Next, determine the present value of each of your cash flows. Let’s say you have a discount rate of five percent, which represents the inherent risks and cost to your bakery over time.
Present value of the cost of the machine = -7,200 / (1 + .05) 0 = -$7,200
Present value of anticipated revenue = 4,000 / (1 + .05) 1 = $3,809.52
Present value of anticipated revenue = 4,000 / (1 + .05) 2 = $3,628.12
Present value of anticipated revenue = 4,000 / (1 + .05) 3 = $3,455.35
To find the net present value (NPV), add up the present values of all cash flows.
NPV = (-7,200) + 3,809.52 + 3,628.12 + 3,455.35 = $3,692.99
This project yields an NPV of $3,692.99. Since this is a positive number, the project is still on the table.
Calculating Internal Rate of Return
The Internal Rate of Return (IRR) is most easily calculated in Excel. To find the IRR, first set up your data with your cash flows over time:
Next, type the formula into the entry bar. In this case, it’s “=IRR(B2:B5).” This yields an IRR of approximately 31 percent. This project’s IRR is higher than the discount rate, indicating it may be worth your investment.
Calculating Payback Period
Finally, you can calculate the payback period on your investment. Enter your data into a table and calculate the cumulative cash flow after each year.
Look for the point where the cumulative cash flow switches from a negative number to a positive one. From this table, you know it will take between one and two years to have earned back your original cost of the machinery. You can’t be sure cookies will sell at a constant rate, so you can’t determine the exact point in time your investment will be returned. But if you’re in a situation in which the cash inflow is guaranteed at a constant rate, you can use the formula in the above explanation of payback period to calculate which month of the year your investment will be returned.
Making a Sweet Investment
After calculating the NPV, IRR, and payback period, you can see your idea to purchase the machinery is a good one. With a positive NPV, an IRR higher than the discount rate, and a relatively short payback period, the owner of the bakery should seriously consider this investment.
This hypothetical scenario is a useful tool you can use as a starting point to determine the profitability of your own projects and make more informed decisions.
Supporting Key Decisions with Finance Skills
Calculating the value you bring to an organization can seem like a daunting task, but with finance skills , there are a host of ways you can prove and predict value. Determining the profitability of your projects can allow you to learn from your wins and shortcomings, pivot when necessary, become more efficient with costs, and move forward with a strategic, big-picture mindset.
Are you interested in learning how finance skills can help drive business decisions? Explore our six-week Leading with Finance course, eight-week Financial Accounting course, and other online finance and accounting courses . Download our free course flowchart to determine which best aligns with your goals.
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