“Startups don’t fail because they lack a product; they fail because they lack customers and a profitable business model.” -Steve Blank

Profitability models matter regardless of the size of a business. These models illustrate how you plan to upscale your business and your goals to make the business profitable.

You might be familiar with revenue models and other business models, but the profitability models are lesser known.

Without further ado, let’s dive in to find out what profitability models are and how you can forecast your profitability.

What Are Profitability Models?

A profit or profitability model is a prediction or a plan solely based on financial data regarding how you can upscale your business to make it profitable. This incorporates the cost of goods sold (CoGs), sales, fixed overheads, variable costs, and different expenses and debts.

A good model of profitability is one that enables you to make financial forecasts as well as adapt the changes in operations.

For example, you are planning to hire new staff or increase production costs. In that case, you must have a profitability model that can account for all of your variable and fixed costs and forecast your profit after attempting these changes.

Let’s have a comparison of the profitability model with other kinds of business models.

Revenue Model Vs. Profitability Model

Revenue is the word used to define a company’s total earnings, whereas profit is what you have in hand after subtracting your costs from the total sales.

In simple words, a revenue model is one that explains the strategies a business will use to generate sales. It does not take the liabilities and account costs into the plan.

A lot of businesses might opt to focus on the revenue model rather than a profit model, especially when they are trying to set aside their goals of profit earning in order to upscale their business. In those times, expansion opportunities and income streams become more important for the validation of a revenue model.

Business Model Vs. Profitability Model

When a business owner comes up with a business model, revenue and profit models are a vital part of it.

A business model is a broad document that takes into account the profitability and the total earnings but at the same time gives equal attention to other components of business like deriving a competitive strategy, value proposition, target goals, and markets, as well as potential business problems and their solutions.  This way, you can focus on the growth and would not weigh heavily on the profitability.

How To Create A Profitability Model?

A profitability model is created the same way as a business model is created. The main components may differ, but it is important to draft a profitability model that makes precise predictions based on the potential market changes affecting the revenue and costs.

This means that you need to have insights into the revenue generation, the pricing model, market saturation, and the capacity constraints that may impact the overall profit.

The best way to create a profitability model is to look at the business’s financial condition on a quarterly basis. This gives an accurate idea about how the profit of the company is evolving.

Core Components Of A Profitability Model

Have a look at the core components of a profitability model.

1. Profit Margin

The company aims for higher profit margins that will eventually result in a higher return on equity. There are a lot of ways that you can calculate your profit margin depending on the business model you choose.

2. Asset Turnover

The asset turnover ratios give a clear picture of how to use the assets efficiently to generate maximum sales revenue.

You can calculate the asset turnover using the following formula:

Asset Turnover Ratio= Net Sales / Average Total Assets

3. Leverage

To know how profitable a company is, you need to know how much in debt the company is and how it is used to run the business with regard to equity.

This means you need to minus liabilities from your assets to know the leverage you have in your hands.

Calculate leverage by the following formula:

Leverage Ratio = (Short Term Debt + Long Term Debt) / Total Equity

4. Return On Equity

This ratio is measured specifically on the returns you get from investors and creditors. This indicates a business’s success or failure because of the owner’s investment.

It is measured by using the following formula:

Return On Equity = Net Income / Total Equity

There are different methods by which profit models can be generated depending on the type of business. some of the most common types of profitability models are:

Types Of Profitability Models

There are three common types of profitability models used by businesses across the globe to measure profit. They are:

1. Analytic Model

A careful analysis of the market and competitors is conducted to make predictions and estimations about costs and profitability. This model is usually used when a business is entering a new market or launching a new product.

2. Historical Model

This model is used when you want to predict a company’s future profitability. In this model, you check out the company’s growth rate in previous years. To get accurate results, you need to consider the future expenses which you cannot derive from the past data.

A historical model is very helpful when you want to come up with a profitability model for the company’s growth.

3. Trends-based Model

Market trends, such as demands or changes in customer views, can impact the profitability of a business. It is very important to consider these trends in order to make an accurate profitability forecast.

For instance, if the trends indicate that the competitors could be taking more market share than you in the coming quarter, you must make adjustments to your business model to combat that beforehand.

Final Words

It can take a business about 2 to 3 years to become profitable. Remember, a business model can only work at some stages of business. The profitability model also needs to be upgraded as per the market and business expansion.

With the help of liabilities and variable costs taken into consideration, different kinds of profitability models are generated so that you can have a clear picture of the future of your business and how long it will take you to achieve your goals.

See Also: What Is A Cost Recovery Method

Farwah Jafri

Farwah Jafri is a financial management expert and Product Owner at Monily, where she leads financial services for small and medium businesses. With over a decade of experience, including a directorial role at Arthur Lawrence UK Ltd., she specializes in bookkeeping, payroll, and financial analytics. Farwah holds an MBA from Alliance Manchester Business School and a BS in Computer Software Engineering. Based in Houston, Texas, she is dedicated to helping businesses better their financial operations.