Designing a Revenue Model
Posted on June 30th, 2009
Every business needs a plan on how maximize profit. This is only possible if you know where your business can collect money from. Profit is relative to amount of investment in a business so it is not the most important measure of financial performance of a business like what most business owner thinks.
For example, a business with a net profit of P100, 000 but with an investment of 2 million pesos is not good compare to a business with the same net profit and has an investment of P500, 000 only. The first would only have a 5 percent return of investment compare to the 20 percent return of invest of the second example.
Profit margin, productivity and financial leverage are the strategic model that can be used to achieve the highest possible return of investment.
Profit margin indicates how you earn for every certain amount of sales that you make. It is computed by dividing the net profit by the net sales. It has a tendency to fall whenever cost of sales or expenses increases and tend to go up when the selling price or volume sales increases.
For example:
P50, 000 -net profit
P150, 000- net sales
= 0.33x 100 percent = 33 percent: meaning in every P100 sales you have P33 profit net
This explains why you have to manage your margin to attain the targeted profit. Like for instance, lowering your expenses in some items or increasing your selling price if the expenses in electric bills shoot up, is necessary to maintain the margin. But financial performance of your business is not completely illustrated by margin management alone. Another thing you have to pay attention to is the productivity of the company.
Productivity is computed by dividing the net sales by the total assets. The productivity ratio would mean how much the business earns for every peso invested in assets.
For example:
P150, 000- net sales
P1, 000,000- total assets
= 0.15 x 100 percent = 15 percent: for every peso invested in assets, the business generates 15 centavos- worth of sales
If the productivity ratio is high, it would be better. But in cases of large uncollected accounts receivable or excess cash in the banks, you might have a low productivity ratio despite having high profit margin.
Financial leverage checks the liability side of your business. It shows how much worth of assets you have for every peso you invest as equity. Net equity is the amount invested in the business. It is sometimes called net worth. Leverage is computed by dividing total assets by net equity.
For example:
P1, 000,000- total assets
P500, 000- equity
= 2.0: two pesos worth of assets for every peso invested as equity
An increase in leverage ratio means instead using your own money, you are using more of other people’s money to increase your sales and profit margin but is risky of bankruptcy if not paid on time.
Return of investment is the product of the three indicators: profit margin x productivity x leverage. An increase in any of the three will give you an increase in the return of investment. In order to achieve the desired return of investment, you must manage to increase any of the other two indicators by the same percentage that the other indicator goes down.
Customizing your Model
An acceptable return of investment may be achieved by focusing on either the productivity, profit margins or leverage depending on how you think you can gain more. Developing your own strategic model has the following advantages:
• It will help you monitor and evaluate current performance
• It enables you to identify potential problems
• Historical comparisons can be done with the statistics you have
• It enables you to set financial targets
• It allows comparison of your actual ratio with industry standards
• Financial impact of any changes that is made with your marketing and operating strategies is anticipated.
In constructing profit model, remember:
1. An accurate financial statement is needed- particularly needed are the balance sheet and income statement for it would be from these documents that data for computation would come from.
2. Involve every employee when implementing the strategy, not only your top management.
