For a business to thrive, it must make a considerable profit (rather than revenue) after accounting for all its operating expenses. It must be seen to have delivered a net income at the close of business and the end of its value chain activities. Any other thing will point to a problem within its value chain.
In contrast, a well-oiled value chain will yield profits for the business, and this profit is almost often concentrated in one segment of the chain. This brings us to the subject of "Profit Pool," a framework that describes the profit-making potential of every business.
What is it?
The profit pool framework is a model that calls for a shift in focus from revenue creation to profit making. It represents the sum of the profits realized at all points in a business's value chain. The points or segments in the business's value chain comprise the activities or processes that create output and add some value to the market.
When these activities are investigated and their profit pools mapped, you can find out where and how the profit is made. You can also identify the profit gaps, prospects, distribution, and other important parameters. This way, you can manage their deficiencies and leverage their advantages to create more profit for your business.
When do we use it?
Below is a brief description of the practical use cases where the Profit pool model can provide value.
For identifying areas of profit concentrations
Almost every business or industry has a most productive or profitable operational area. The profit pool model can help you trace these areas. You can now leverage them to yield even better results.
For examining competitive dynamics and industry structure
By mapping your Profit pool, you can access the dynamics that exist in your business and learn how it impacts operations. You can find out what key activities and processes influence the structure and performance of your value chain. This can help you create more efficient and optimal processes.
For identifying new sources of profit
Profit pool mapping can provide insights into what business segment holds the brightest prospects. This can help you further achieve your growth, expansion, and diversification targets.
To determine the profitability of a business
Profit pool mapping can help you identify your business's profit pools and the size of the pools. This way, you know if your work efforts yield any gains or if a profit gap needs closing somewhere.
To help make decisions about pricing, operations, etc.
An extensive profit pool mapping can set you on course to fully understand your business. The result is improved decision-making on matters that affect the business.
What business questions is it helping us to answer?
By identifying your Profit pools (via profit pool mapping), you can find the answers to the following business questions.
Is the business profitable?
Is your business yielding a significant profit for its shareholders, or are you just managing to break even? The answers to these crucial questions can be found in profit pool mapping.
Where is the profit being made?
This deals with what segment of your value chain contributes most to your business's overall profit-making. Perhaps it is the usual suspects (sales and distribution), a key process optimization, or a competitive advantage.
How is the profit being made?
This leads you to an in-depth review of the process, structure, or activity that creates the profit pool. It could be due to certain economies of scale, an innovative solution, or an efficient supply chain. The aim is to identify it and then leverage it for more gains.
How can you maintain the profit pool?
If your profit pool is not well managed, it may become stagnant or dry up. The key is to identify the source or feeder pools and water them with the resources needed to sustain them. This could mean investing in a key operation or putting more hands on deck.
How do we use it?
The process involved in creating and mapping a profit pool is split into five steps, as defined below.
Define the profit pool's boundary
Highlight what value-chain activities contribute to your profit pool. Also, sum up the activities, processes, and operational sectors that form your business's value-creating profile.
Estimate the pool's overall size
Next, obtain a standard estimate of the cumulative profits deposited by the profit pool. This puts a number behind the profitability of the business as a whole.
Estimate the profit for each value chain activity
Segment your value-chain activities according to their profit pools. This action will help you examine the contribution of each activity to the overall profit pool.
Reconcile the estimates
Here, you compare the outputs from the previous two steps and make key inferences.
Plot the value pool chart
Plot a chart with all the value chain activities (and the generated revenue) on the x-axis and the percentage operating margin on the y-axis. The size of the profit pool is depicted in the area formed from the plots.
Practical Example
A steel products manufacturer uses the profit pool to identify where its profits are concentrated. After the extensive mapping of its value-chain activities, it identifies the various existing profit pools.
It identifies its high-yield reinforcement bars-producing segment as its biggest profit pool. It resolves to devote more resources to this segment and commit more workforce to the factory floor. Ultimately, it can optimize production processes and expand to make more profit.
Advantages
It can map out profit opportunities
Using profit pool mapping, you can find out what segment of your business possesses the biggest prospects. Those segments with the greatest potential for profits and growth will be highlighted to be reinforced later.
It is easy to implement
The profit pool model does not pose any serious implementation problems. To get the relevant data, you only need intensive value-chain analysis by knowledgeable persons.
It can help you optimize operations and maximize resources
An in-depth profit pool mapping will identify critical gaps in your operations that impact performance and reduce profit. It can also help you identify what sectors to deploy resources and concentrate efforts to.
Disadvantages
Problem with access to critical financial data
If the numbers don't add up right, your profit pool mapping may not be fit for its intended use. You must have the relevant data infrastructure to supply the right data. And this might be too much to ask for start-ups and emerging businesses.
It is a time-consuming process
The intensive calculation associated with profit pool mapping may be time-intensive. The value-chain analysis will have to probe key operational areas, which will take some time.
It can be complicated for large companies
The complexity of profit pool mapping will increase in scale as the company's size increases. This could make it more difficult to execute for big companies and conglomerates with more complex value chains.
Continue to explore strategy tools here.
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