Welcome to our series on using case interview frameworks to break down consulting case interviews. Today, we’re looking at the profitability case interview framework, which are probably the most important.
*In case you missed them – in our first article, we provided an overview of frameworks and how you can use them to solve any case that gets put in front of you. In our last article, we took an in-depth look at Market Sizing.
Why is the profit formula most important, you ask? Think of it like this: if business is like our solar system, then profit is the sun around which the celestial bodies revolve. As hard as it may be for some of you to admit, without the sun (the green stuff, Benjamins, clams, coin) everything falls to pieces – quickly. It’s not that we’re saying the profit equation makes the world go round…well except when it comes to business, we kinda are.
With that in mind, nailing profitability analysis is an absolute must; so without any further delay, here are the 4 situations in which you can be sure to apply the case interview profitability framework.
4 Ways To Use The Profitability Framework:
This seems like a bit of a no-brainer here; don’t all companies want to grow, all the time?
But what’s likely true about the case interview you will be presented with is that your client is ready to launch all-out, no-holds-barred business growth strategies to take on the future in the hopes of seeing significant growth in a short period of time, rather than just incremental growth over a longer period.
It could be that your client wants to grow revenues, market share, profits, or all of the above, but just increasing revenues won’t be enough, because increasing revenues often means increasing costs. How can you take the profit and loss statement, demonstrate an understanding of how to calculate profit margin, and run through profitability ratios to demonstrate your finesse?
In short – how can you help your client in its quest: how to find profit?
Then, you’ll need to include cost volume profit analysis. In other words, you’ll need to factor in which operating costs are going to be increased for the new initiative, any costs to the client for launching the new initiative, and maybe even calculate the payback period to demonstrate the true impact on the business.
Here’s a rule for profitability – every time revenues are included (growth usually implies revenue growth), cost should also be included. Leaders don’t trade off revenue vs. profit – they manage to both revenue AND profit. Even if you get pointed squarely towards either cost or revenues by your interviewer, make sure you keep the cost benefit analysis in your mind (and in your structure) at all times.
This is every CEO’s biggest nightmare, but just observing declining profits won’t do you any favors. You’ll be expected to present a plan that will:
- Stop the decline in its tracks
- Get the business going in the right direction
If you get a case that deals with declining profits, the first question you should ask is “why?” Declining profits can be caused by one or both of the following:
The basic question here is, “why have sales gone down?” It may be that the customer needs have changed, or it may be that some new fierce competitor has come on the scene. Whichever it is, you need to figure out what is happening and then why it is happening.
Either the variable costs or the fixed costs have gone up. The goal here is to once again figure out what has happened and why it has happened.
The good news? Corporate profits, when mentioned in cases, usually refer to operating profits (the purview of consultants), not net profit (the purview of tax advisers like the Big 4). At least that means you can cross off “how to calculate net profit” from your “things-to-learn” list.
Creative Cost Benefit
In disruption, potential benefits are either increased revenues or decreased expenses. In these questions, the cost is often investment costs; how much is needed to facilitate the new idea. The cost vs benefit is defined as the return on the cost.
These types of cases are often used for non-profit clients whose ultimate success is not based upon profitability, but social measures or the greater good. A good example from our book, The Consulting Interview Bible is:
“The City of New York is considering shifting their parking meters from coin-operated to digital. Is this a good idea and why or why not?”
However, in a world of increasingly high profile disruptors like Uber, Netflix, and Dollar Shave Club, cost benefit questions do not apply exclusively to non-profits.
Your client is looking at option A vs option B, but needs the benefit of your top level analytical skills and insight before making their decision. In this situation, you need to quickly assess the revenues and costs associated with each option, ascertain which is the more profitable, and provide your recommendation based on your findings.
How to Calculate Profit
For the purposes of cases, which are simplified versions of real life, you do not have to demonstrate wizardry in Accounting. You do not have to memorize all of the possible profitability ratios.
However, you do need to know how to calculate gross profit (Revenue – COGS).
Then, you need to know how to calculate EBITDA (Gross profit – OpEx).
Then, you need to know how to calculate Operating Profit or EBIT (EBITDA – Depreciation – Amortization).
You also need to know which of these is larger, and what is included and excluded in each. You need to have a strong enough grasp for a situation where, when someone says “profit,” you can meaningfully defend which profit you believe they mean, and why.
Finally, it’s nice to know how to calculate Net Profit (EBIT – Interest – Taxes – One-time expenses), although as mentioned before you should not have to use it.
How to Use the Profitability Framework
The first thing you need to do is identify which question you’re addressing. Then you can begin to apply the case interview profitability framework – creatively.
Next, determine the revenue/revenue drivers. Remember, as a consultant, you will need to look at revenue by segment. This means that instead of doing a simple revenue calculation of:
Average Price x Quantity = Revenue
In reality, with more complicated software (or at least Excel), you’ll do it as follows:
(Price Segment 1 x Quantity Segment 1) + ( Price Segment 2 x Quantity Segment 2) = Revenue
Aside from knowing the profitability equation, you should also be aware of factors that impact profitability:
Factors That Impact Profitability:
Overall market demand
- “Are there a lot of companies providing an identical service?
- Is the market declining?”
- “Are they driving prices down?”
Customer (remember, customer does not necessarily equal final consumer)
- “How much buying power do they have?”
Overall market demand
- “Is it decreasing? Is this industry-wide?”
- “Are they stealing customers?”
- “Are their needs being met?”
- “Are we marketing through the best and most effective channels?”
That was a brief look into revenues, now let’s look at what can affect the costs side of the equation in the profitability framework.
Factors That Impact Costs:
- Fixed Labor
- Other fixed costs, e.g insurance
- COGS (Cost of Goods Sold)
- Variable Labor – Have wages increased without a corresponding increase in price?
- Distribution Costs
- Other Variable Costs
As long as you solve the profitability framework cases using simple structures in 2 levels (what is changing and why), you’ll be well on your way to acing the case. See our introduction to case interview frameworks.
This is just a brief look at the case interview profit framework, but it’s enough to get you started. If you’d like more help or want to figure out how to calculate the profit equation, book an Interview Prep Session with us.