To Define Profitability, Consider Indirect Benefits

If you ask seven business professionals to define profitability, you are likely to get seven different answers. There are several ways of viewing profit. In the broad sense, defining profitability is simple: making money. In a more detailed sense, definitions vary depending (for example) on the timeframe and whether indirect benefits are considered.

A profit and loss statement (P&L), captures various levels of quantitative–or “accounting”–profit: gross, net, before-tax, and after-tax (See this profit and loss form for an overview).

When developing a product or service, it is helpful to generate a pro forma P&L in order to project profit. The true impact of a particular program, however, is often more subjective than the accountants would have you believe.

Indirect Break Even Point Considerations

A profit and loss form can capture the direct revenue and costs associated with a program, but long-term impact, competitive considerations, and indirect benefits to your business can be less tangible.

The full benefits gained from a marketing program, for example, are not directly and immediately measurable. Many benefits happen over time. Advertising; brand building and awareness; Web site improvements; and other types of programs may be profitable in the long run but appear costly in the short term. A better approach for these programs is to set aside a budget to spend on the program(s) with the most potential for long-term success.

Investments in improvements–such as a redesign of your Web site–may seem unprofitable at first, but are nonetheless the right thing to do. Many of these programs are beneficial because they keep you from losing business to competitors over time. For these types of projects, the correct question to ask is “What happens if I do this versus if I do not?” Know how your business must grow over time to make the improvement worthwhile and compare it to actual growth potential. If the cost is not reasonable compared to the potential, then look for other solutions.

Another reason the benefits of a marketing program may not be directly measurable is because new customers gained as a result of the program may, over time, buy from you more than once (i.e. have a lifetime value that is greater than the profit from a single purchase). Additionally, happy customers tend to refer additional customers by spreading the word about your goods and services. Both of these factors indirectly increase a marketing program’s overall profit.

Making Revenue and Expense Assumptions

Predicting profitability can be a series of “best guesses” based on assumptions. In fact, you could probably manipulate your assumptions to make a program as profitable (or unprofitable) as you wish. A more successful approach, however, is to try to legitimately forecast profit. Be as reasonable as you can with assumptions, and then decrease your expected revenue by some factor (up to 25%). Costs or revenues can come in worse than reasonably expected for a variety of unforeseen reasons.

Figuring Break Even Point

Knowing break even points can help you decide a reasonable budget for your promotional programs. One way to do this–while also taking into account longer term profits–is by basing the break even analysis on lifetime value of new customers (In other words, the amount of profit you expect to earn from new customers gained through the promotion, both now and in the future). To figure this type of break even point, you should know:

1) Program’s expected response rate: Defined as the percentage of those exposed to your program that will take you up on your call to action, or become leads. 2) Program’s expected conversion rate: The definition of conversion rate is the percentage of responders who actually become customers. 3) Lifetime value of a new customer: The amount of dollar profit you will make from the customer over a certain time period. It is common to define lifetime as anywhere from 18 months to two years.

Response and conversion rates can vary widely, depending on how targeted your prospects are, how well your offer is written, and how involved the purchase decision. Type of program also has an impact on your response and conversion rates. To estimate these rates for a particular program, you can look to your past experience and/or ask the program vendor. You can also search on general marketing and research Web sites to find rules of thumb for the type of program (you may expect a Website banner ad, for example, to have a much different response rate than a search engine pay per click ad). In all cases, document your assumptions. You will need them later to analyze program results.

For more details about and examples of break even point formulas, read “Figuring Break Even Point.”