Log in

ISM Article

Impact of Revenue on Profitability

1 May, 2010 By: Mike Dudek imageSource

Impact of Revenue on Profitability

Many thousands of companies are in the business of selling
“razors & razor-blades”. This business model first calls for you to sell a
product (the “razor”) and then sell follow-on after-market (the “razor-blades”);
often in the form of services and supplies.

For most razor & blade businesses, the initial product is
sold at a relatively low profit margin, especially after taking into
consideration a combination of direct and indirect expenses including a healthy
sales commission to the sales representative. The more lucrative profits from
such sales are generally derived from follow-on high margin aftermarket revenue.
These after-market revenue streams often are locked in by contracts and
represent an ongoing cash flow annuity from a captured customer which represents
the most valuable component of an owner’s business. 

Although many companies earn a portion of aftermarket
revenue on a T&M basis (time and materials), a preferable approach used to
capture and perpetuate the customer relationship is to enter into multi-year and
evergreen contracts which allow for periodic price increases. Contracts are
exceptionally valuable because they create consistent, predictable, profitable
revenue and cash flow annuity streams.  Such predictable cash flow streams
enable owners to more accurately plan and predict the future; consequently such
owners find it much easier to attract investment capital.

The growth phase of razor & blade companies can be
extremely expensive.  It may require extensive energy and resources to sell
enough razors to generate the invaluable follow-on streams of blade revenue. 
Profit returns during the growth stage, could be very narrow even for companies
which are managing operations and executing very effectively. In analyzing such
companies, both insiders and outsiders (owners, managers, bankers and investors
alike) must assess company performance in sufficient detail to properly
understand where the business has been and where it is going. Sometimes, a less
profitable company could be the more valuable entity; especially if it is one
that is laying the foundation for a brilliant future. A very profitable company
on the other hand, might actually be headed in the wrong direction.

Impact of Functional Revenue
Mix on Profitability

In assessing razor & blade companies, one has to understand
the impact of revenue mix on profitability.  The thousands of companies with
such business models include the following classic examples:

Copier and printer dealers
– selling lower margin copiers and printers to capture more lucrative services
and supplies aftermarket;

Computer dealers
selling lower margin hardware and software to earn higher margin maintenance,
repairs and network monitoring services;

Telephone dealers
– sell low margin phones to obtain high margin accessories and monthly service

Cable companies
selling or even giving away low margin cable dishes or digital boxes to lock-in
monthly contract annuities and add-on services;

Car dealers
selling cars to capture future repair business; and,

Security companies
– give away alarm systems in return for the monthly service contracts.

During growth and even maturity life cycle phases, many
such razor * blade companies strive and struggle to achieve low to medium
single-digit profitability. Such relatively low profitability makes investors,
and even some owners who do not sufficiently understand their own numbers,
apprehensive about the future. Acquirers of such companies are often concerned
about inferior profitability but might miss the bigger picture and opportunity.
More profitable companies are almost always perceived to be better managed and
substantially more valuable to many untrained and even highly trained eyes.

Caution is recommended in drawing any hasty conclusions.
More in-depth analysis and assessment of a company’s functional business
segments is required in order to arrive at a more informed opinion. Valuable
lessons can be learned by analyzing Functional Profit & Loss Statements of
companies in similar industries at different stages of the life cycle.

Example of Functional P&L

An examination of the following functional P&L’s
illustrates the dramatic effect of revenue mix alone on profitability. Each of
the following company P&L’s have mostly identical attributes, including:

1. Identical revenue - $25,000,000

2. Identical functional cost %’s & margins - equipment margins at 34%, service
at 84%, and supplies at 34%;

3. Identical direct expense %’s - as a % of functional revenue and functional
gross profit;

4. Identical functional operating contribution margins; and,

5. Identical administrative expense as a % of revenue at 15%.

Yet, bottom line profitability is substantially different.
The low profit company in Scenario A has a 7% profitability return and generates
$1.8 million profit. The medium profit company in Scenario B has a 10%
profitability return and generates $2.5 million profit. The high profit company
in Scenario C has a 13% profitability return and generates $3.2 million profit.

So what is different? Why are the profit dollars and profit
return rates so vastly different for three companies that have identical
functional cost, margin and expense relationships? Revenue mix is different. 

Scenario A – 40% Equipment & 60% Aftermarket

Functional P&L Equipment

Aftermarket 60%

Revenue Mix Equipment Service Supplies  
Sales $10,000,000 $10,000,000 $5,000,000


Rev Mix       40%
Cost of Sales $6,600,000 $1,800,000 $3,300,000 $11,700,000
% of Revenue 66% 18% 66% 66%
Gross Margin $3,400,000 $8,200,000 $1,700,00 $13,300,000
% of Revenue 34% 82% 34% 53%
Direct Expenses $2,300,000 $3,800,000 $250,000 $6,350,000
% of Revenue 23% 23% 5% 25%
Operations Contribution $1,100,000 $4,400,000 $1,450,000 $6,950,000
% of Revenue 11% 44% 39% 28%
Admin Expense       $3,750,000
% of Revenue       15%
% of GM       28%
Operating Income       $3,200,000
% of Revenue       13%

It’s all about revenue mix.  As summarized in the chart
below, the “Scenario A” Company returns 7% profitability by generating 60% of
revenue from lower margin equipment sales and only 40% of revenue from higher
margin after-market sales. Scenario B Company returns 10% profitability by
generating 50% of revenue from lower margin equipment and 50% from higher margin
aftermarket revenue.  Scenario C Company returns 13% profitability by generating
40% of revenue from equipment and 60% from aftermarket. Understanding the impact
of these various revenue mixes on profitability and the underlying reasons
behind the mix could not be more profound and critical to understanding the
overall business performance and value.

Without digging deeper to understand a lot more about other
quantitative and qualitative attributes,  both insiders and outsiders might
immediately conclude that the “13%er” is a much better managed and more valuable
than the “10%ER” and “7%er”.  Consider the consequence of applying an identical
purchase price multiple to the $3.2 million company versus to the 1.8 million

More investigation, analysis
and understanding is warranted – “what if”…

What if the 13%er was selling only old technology and was milking the
aftermarket base and customers were dropping off at a rate of 10% to 15% a year?
What is the 13%er stopped replacing critical components on the machines in its
customer base?  What if the 7% was selling new technology and growing at 20% a
year? What if the 7%er is lopping on valuable chucks of aftermarket each year
which will rapidly increase bottom line profitability once scale is achieved? 
What if the 10% company was mature and was selling a combination of old and new
technology?  What if….?  What if …?

Examining only a few additional attributes about a company
besides profitability can provide critical insight and could result in an
entirely different determination about which company is more valuable and a
better investment for a particular investor.  Investors have different

What lessons can owners & investors learn from examining
revenue mix in razor & blade companies and what steps should be taken? Whether
you are an owner, an operational executive or a potential acquirer, look beyond
bottom-line profitability to better understand business performance. Consider
the following 3 steps in your investigation: 1) Understand the basic impact of
your revenue mix; 2) Examine additional qualitative & quantitative variables
contributing to your mix & performance; 3) Study trends & changes in functional
revenue mix (3-year look minimum). If you are in the razor & blade business,
keep selling those razors or you will lose that invaluable blade business!

Mike Dudek is the founder and owner of Zygoquest and the
Law Office of Mike Dudek. Zygoquest provides customized merger and acquisition
services and advisory services to owners who are to buyers and sellers of
companies.  At (610) 873-6555 or mdudek@zygoquest.com.

WebinarCase Studies and White PapersSand Exchange Blog

imageSource Magazine Quick Links
Upcoming Events
ITEX Expo & Conference
©2015 Questex, LLC. All rights reserved
Reproduction in whole or part is prohibited
Please send any technical comments or questions to our webmaster