In this blog post, I am going to discuss the use of Profit Tree’s as a tool to aid analysis of your business. If you haven’t already come across them, the principle is pretty simple. You effectively build out a tree structure from ‘profit’ onwards until you reach a suitable number of specific layers to aid detailed analysis. The idea is that in mapping out all of the elements that contribute to profitability, you can conduct analysis to identify ways in which you can improve it. Asking a question like ‘how can we grow our revenue’ is too high level for effective and complete analysis. In my experience it is much better to break revenue down into its component parts each of which will be a much easier ‘bite sized chunk’ to address.
Building out the Profit Tree
In simple terms, profit is a function of revenue and cost.
Revenue and Cost become new branches to the tree and then you continue to build from there i.e. revenue is a function of the volume of your sales (or billable hours) for the price/fee that you can charge them in the marketplace. So, sales volume and price become new strands of the revenue branch and so on. Costs might be further broken down into say fixed and variable costs (variable costs in this context including costs charged to a particular client project).
You can keep going from there until you have reached about 4-5 layers down on each branch. There is no one right way to do this and in the past I have built trees that shared the same early branch structure but then looked different at the more detailed layers. When you get to the final layer, you will then ask questions about how you could improve each element at that level. Improvements at each of the level 4/5 branches of the tree should contribute to the improvement of profitability overall.
Of course, this will also depend on your reason for conducting the analysis and the scope of the exercise. It may be the case that your focus is on reducing costs and that is where your effort is placed. Alternatively, you may decide that your best strategy is to focus on generating more revenue rather than cutting costs. Interestingly, a study of 25,000 companies published in the Harvard Business Review (Three Rules: How Exceptional Companies Think, 2013) concluded that there are three rules of great companies:
Rule #1 – Better before cheaper (it is best to compete on a differentiator other than price)
Rule #2 – Revenue before costs (prioritise increasing revenue over reducing costs)
Rule #3 – There are no other rules
Here is an example of a full profit tree developed to aid my own analysis:
In the example above, the initial goal of my analysis was to be as complete as possible and to develop as many branches as I could in a logical manner – without initially worrying about whether a branch was desirable. There may be parts of the tree that you have no intention to address i.e. taking action wouldn’t fit with your strategy, purpose or values. In this example, I got to 4/5 layers depending on the specific branch.
To take an example from the tree, one of the levers of improving revenue is to increase the amount that you can charge for your services. In developing this further you might consider investment in your services, invest in training and development or significant brand improvement.
I have personally found profit trees useful at times in working through every branch of the tree to see whether improvements can be made. Mapping out all of the areas involved in the generation of profitability ensures that your thinking is as complete as possible.