Factors that Affect Business Profitability | tutor2u Economics
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Factors that Affect Business Profitability

  • Levels: AS, A Level
  • Exam boards: AQA, Edexcel, OCR, IB

Profits are the life-blood of a market economy. Achieving a sufficiently high level of profit is crucial in sustaining long run business growth. What strategies can businesses adopt to improve their profitability?

Factors affecting Business Profitability - Revision Video

Price discrimination

Price discrimination occurs when a business charges a different price to different groups of consumers for the same good or service, for reasons not associated with costs. Price discrimination benefits businesses through higher revenues and profits. A discriminating monopoly is extracting consumer surplus and turning it into supernormal profit/ producer surplus

Ways to improve profits

Increase quantity sold through price discounting and increased marketing

  • Higher sales volumes = higher total revenue, assuming that the selling price is not lowered too much
  • Makes better use of production capacity (i.e. fixed costs should not rise)
  • May result in higher market share giving extra advantages over rivals including buying power over suppliers

Evaluation: The impact of lower prices depends on elasticity of demand, total revenue may actually fall if price has to be reduced to achieve higher sales volumes. Does the business have the supply capacity to sell more? This depends on the price elasticity of supply.

Evaluation: Competitors are likely to respond - bring some game theory into your answer. Marketing efforts may fail – e.g. promotional campaign does not generate results. Fixed costs might actually rise – e.g. higher marketing costs in the short run to drive higher sales.


Raise the average selling price on output sold

  • Higher selling price = higher total revenue (assuming quantity sold does not fall in response)
  • Raising the price allows for a higher profit margin on each unit sold
  • Maximises the value extracted from customers (i.e. turning consumer surplus into producer surplus)
  • Customers may perceive the product as being of a higher quality
  • No need for extra production capacity and investment as output likely to remain close to current levels

Evaluation: Impact on sales depends on price elasticity of demand - easier to do when demand is price inelastic. Sales value may actually fall price rise is matched by an even bigger fall in quantity sold. It will work if customers remain loyal and still perceive product to be good value or cheaper relative to those of the closest rival product

Evaluation: Competitors are likely to respond (e.g. prices lower or hold their prices - the Kinked demand curve model might be used here). Some customers may decide to switch to competitors - causing a loss of market share

Reduce variable cost or fixed cost per unit

  • Successful cost-cutting brings about an increase the profit per unit sold as price is now well above the average cost (P>AC)
  • Higher profit margin on each item produced and sold, no need for a change in market price - so cost reductions feed through directly into higher profits

Strategies for cost-cutting:

  • Use market power to persuade suppliers to offer better prices
  • Improve productive efficiency to increase productivity and lower wastage

Evaluation:

  • Lower input costs might mean lower quality inputs – which can lead to greater wastage
  • Customers may notice a decrease in product quality and switch to rival products
  • Productivity may suffer if cost cutting comes about through large scale redundancies

Some more options for improving profits

Reduce product range

  • Business often has too many products = complex operations & inefficiency
  • Some products may be very low-margin or even loss-making. Cutting the product range helps to remove the expense of a cross-subsidy

Outsource non-essential functions

  • A way of reducing fixed costs
  • Focus the business on what it is good at
  • Areas to outsource: e.g. IT, call handling, finance

Statistic: Apple's net income in the company's fiscal years from 2005 to 2014 (in billion U.S. dollars) |<img src=
Find more statistics at Statista

General evaluation points

  1. Profitability is ultimately determined by the market price that a business can charge compared to the supply-cost per unit
  2. Some costs are under the control of businesses e.g. labour costs but many costs are influenced by external factors e.g. changes in the minimum wage, volatile world commodity prices, changes in government regulations
  3. Strikes can also have a damaging short term effect on profits - read this example
  4. Political events can have significant effects e.g. the impact on the profits of EU companies selling to Russia as the number of trade sanctions has increased.
  5. Profitability is affected by changes in a country's exchange rate - something over which a business has little or no control. An appreciating currency for example might cause a fall in sales and lower operating profits for a business that relies heavily on exporting their products.
  6. Many businesses seek to hedge against uncertain input costs by using forward markets e.g. for oil and gas - e.g. an airline might buy aviation fuel months ahead of using it at a futures price
  7. In some industries, market demand is strongly cyclical i.e. it rises when an economy is doing well but contracts in a slowdown or recession when real wages are falling
  8. The profitability of one business is affected by the pricing and non-price competitive strategies of rival firms. In oligopolistic markets, we might see examples of tacit or explicit collusion, designed to reduce uncertainty and achieve a higher level of joint profits for businesses involved.

Restoring profitability - Peugeot Citroen

Peugeot Citroen is Europe's second largest car maker but in recent years it has been suffering large operating losses. A new CEO has helped to turn the business around and restore it to profitability. Peugeot's return to operating profit has been attributed to the companies' success at slashing costs, overseeing job reductions, shrinking inventory, lowering capital spending and raising prices. Rising sales to China have also helped to boost revenue.

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