These examples provide additional information to help you understand how profitability would fall in the circumstances outlined in the questions on page 324 (Why is ratio analysis needed?) of Chapter 8.

The questions asked about the possible reasons behind the reduced profitability of the pottery company fall into two categories: reduction in selling prices (including discounts to bulk buyers) and rising prices of input materials. Let’s look at how explanations for reduced profitability falling into these two categories will cause the profitability of the company to fall.

Example 1: Reducing Selling Prices = Lower Profitability

As an example, let us assume that the pottery company has sold plates in the past at £7.50 each. The cost of making each plate is £4.50. The current profit on each plate sold is therefore £7.50 – £4.50 = £3.00. This gives a profitability % on the sale of each plate of £3.00 (profit on each plate sold) ÷ £7.50 (selling price of each plate) x 100% = 40.00%.

The pottery company then decides to reduce the selling price of each plate to £6.75 (perhaps due to a recession forcing the owners to reduce prices to attract customers or to a rival business opening in the area forcing prices down or as a discount to bulk buyers of plates or in an attempt to increase market share). The cost of making each plate is not reduced by this reduction in selling price decision and remains at £4.50 per plate. Therefore the profit on each plate sold is now £6.75 – £4.50 = £2.25. This gives a profitability % on the sale of each plate of £2.25 (profit on each plate sold) ÷ £6.75 (selling price of each plate) x 100% = 33.33%.

Each sale was generating 40 pence of profit for each £1 of sales, but, with the reduction in the selling price, each sale is now generating only 33.33 pence of profit per £1 of sales, so profitability on each sale is now lower.

What effect will this reduction in selling price have on overall profit and profitability? Let us assume that the pottery company originally sold 7,500 plates a year at a selling price of £7.50. Following the reduction in selling price to £6.75, the company now sells 9,000 plates. The following table compares the two outcomes:

Despite selling more plates at the lower selling price, the pottery company has made less profit. The cost of producing each plate has not fallen in line with the selling price but has remained the same, so a reduced selling price with no corresponding decrease in costs will result in lower profits and lower profitability. (Check for yourself that profit ÷ sales is 40.00% and 33.33% respectively in each of the two outcomes in the table above).

Page reference: 323-324

Heading reference: Why is ratio analysis needed?

Example 2: Increasing Costs = Lower Profitability

Now suppose that the costs of materials and labour in the production of plates rise from £4.50 per plate to £4.95 per plate. The directors of the pottery company decide that the market will not accept a rise in the selling price of plates so they accept the cost price increase without raising selling prices to compensate for the loss of profit.

What effect will this increase have on profitability?

As we have seen, the current profit on each plate sold is £7.50 – £4.50 = £3.00. This gives a profitability % on the sale of each plate of £3.00 (profit on each plate sold) ÷ £7.50 (selling price of each plate) x 100% = 40.00%. With the cost increase, profit on each plate sold will now be £7.50 – £4.95 = £2.55. This gives a profitability % on the sale of each plate of £2.55 (profit on each plate sold) ÷ £7.50 (selling price of each plate) x 100% = 34.00%.

Each sale was generating 40 pence of profit for each £1 of sales, but, with the increase in the production cost of each plate and no corresponding increase in the selling price, each sale is now generating only 34 pence of profit per £1 of sales, so profitability on each sale is now lower.

What effect will this reduction in selling price have on overall profit and profitability? Let us assume that the pottery company sells 7,500 plates a year at the selling price of £7.50. With no reduction in the selling price, sales remain at 7,500 plates a year.

The sales made have cost more, so the pottery company has made less profit. The selling price of each plate has not risen in line with the costs of production but has remained the same, so an increase in costs with no corresponding increase in sales revenue will result in lower profits and lower profitability. (Check for yourself that profit ÷ sales is 40.00% and 34% respectively in each of the two outcomes in the table above).

Page reference: 323-324

Heading reference: Why is ratio analysis needed?