Revenue: if revenues have decreased and costs have not changed, this suggests that the issue relates to revenues. Your next step should therefore be to assess the branches underneath ‘Revenues’ in order to determine whether that change is the result of a fall in the price per unit or a fall in the number of units sold. If however revenues have remained stable but costs have increased, you should ‘drill down’ the ‘Costs’ branch instead (i.e. assess the sub-branches linked to the ‘Costs’ branch).
Costs: the total cost figure depends on both variable and fixed costs, so you need to determine which of the two types of costs has increased. If variable costs have increased, then drill down further to determine if the change relates to the cost per unit or the number of units sold. If fixed costs have increased, you may have to segment the fixed costs to see whether a certain type of fixed cost has increased to an unsatisfactory extent. Remember that an increase in fixed costs may indicate investment has taken place (e.g. investment in new plant & machinery), which in the long-term could increase revenue and improve profitability (even if profitability has been negatively impacted in the short-term).
A drop in profitability may sometimes be driven by a combination of changes on both the revenues and costs sides. If this is the case, you should drill down both branches (separately) until you find the source(s) of the problem. If the interviewer specifies that the case study strictly relates to one branch in particular, you can focus on that specific branch. Depending on the company’s objective in a particular case study and the style of interview, you may next be expected to move onto the Business Situation Framework. This can help you to structure your analysis of important qualitative factors that may have had some influence over the issue(s) the company is facing (e.g. whether the issues are industry-wide or company-specific).
There are various strategies that businesses can employ to minimise or stabilise costs. For instance: maximising economies of scale; integrating into the supply chain; outsourcing; offshoring; entering long-term contracts; using Just-In-Time Production strategies and utilising derivatives.
- Economies Of Scale: the cost advantage gained as output increases. This cost advantage arises when fixed costs are spread across a greater quantity of sales. When organisations place larger orders with suppliers, suppliers will usually pass on a proportion of the cost savings they receive through economies of scale to that firm, in turn reducing that firm’s input costs.
- Integrate Into The Supply Chain: the supply chain is comprised of contributors involved in the process leading up to the sale of a product (e.g. manufacturers). Typically, each contributor will charge prices that include a profit margin. If one company takes control of two or more stages in the supply chain, it will not have to pay this additional margin and costs may consequently decrease.
- Outsourcing: contracting out roles or processes (e.g. customer services, distribution, or marketing) to external companies. Businesses can benefit in numerous ways, for example through outsourcing to parties with greater expertise or experience in undertaking a particular role; or through the flexibility outsourcing may enable. For instance, if demand for a firm’s products or services decreases, it must still pay employee wages (at least in the short term). However, if a firm outsources its labour requirements (i.e. pays another company to provide employees as and when they are required) and demand subsequently decreases, the firm can simply end its contract with the company that provided the employees. This would enable the firm to consequently avoid paying for employees that are no longer needed (subject to the terms of the outsourcing agreement).
- Offshoring: shifting elements of the business (e.g. production) abroad, usually to jurisdictions where costs are lower.
- Long-Term Contracts: these can enable companies to more accurately predict future costs, or to mitigate the risk of price increases if, for instance, the price of raw materials increases globally. Participants in the supply chain may also provide more favourable rates to businesses willing to commit to long-term relationships.
- Just-In-Time Production: a strategy that involves companies receiving goods (e.g. raw materials) right before they are required for the production process and/or producing goods for sale right before they are required by customers. These strategies can increase efficiency, decrease the costs of storing inventory and minimise waste (if inventory does not exist, then it cannot break/expire etc.). However, if a company does not accurately forecast demand or coordination breaks down between that company and its suppliers (meaning supplies are not promptly delivered), this could result in delays that impact upon that company’s ability to meet customer demand (and thus generate profit).
- Derivatives: financial contracts relating to underlying assets (such as securities or commodities). Examples include futures, which are agreements between parties to engage in a transaction on a predetermined future date at a specified price; and options, which give one party the right (but do not obligate them) to purchase or sell a product on a predetermined future date at a specified price. These derivatives can help companies to better predict future costs and mitigate the risk of adverse price movements reducing profitability (this is known as hedging risk). This can in turn facilitate more accurate financial planning.
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By Jake Schogger - City Career Series