Profit Models (Part 2). What is a profit model and why should organisations use them?

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In our last blog James and Gordon had come to an impasse. James, as Sales Director, had created a strategy based on a KPI that targeted an increased number of new sales on book. Gordon, as Credit Head, had an opposing KPI requirement: maintaining bad debt within acceptable limits. Neither of these two goals appeared to be compatible with each other as Gordon’s restrictive credit scoring was limiting James’s number of new sales. The proposed solution to this conundrum was to set up a profit model KPI as an alternative, where success is measured by overall increased profit for the company.

For those of you who missed part one of this blog (read it here), profit models are models that are built on historical data to identify ways in which company profit can be increased. The application of a profit model to strategy development involves prioritising increased profit over increased number of new sales and reduced risk level. This enables and encourages functional areas to work together towards achieving a common goal rather than concentrating their efforts on seemingly opposing goals.

Let’s discuss the application of a profit model in more detail. Each customer depending on their propensity to pay and product choices results in a certain amount of profit. The more customers we have the lower the average generic costs are (as we discussed in part one of this series). The profit model states that if we onboard sufficiently more customers who have slightly riskier profiles, then greater overall profit should be generated as the increase in average bad debt is less than the decrease in the average generic costs per account.

If we apply some hypothetical numbers to our scenario it is easier to picture how this would work practically.

James and Gordon decide to work together to develop a new scorecard that allows products to be sold to slightly riskier clients. This new scorecard results in celebrations in the sales department as James’s customer base increases by 8%. However, as these new customers are risker the company now has a lower average disbursed amount (i.e. average loan size drops $5 000 to $4 800) which leads to a decrease in revenue per account. In addition to this, Gordon tells James that the cost of collections has increased, as has the amount of bad debt (by 5%). The summary of this sad state of affairs is that the overall profit margin has decreased by 2% and the new scorecard (Challenger A) has failed to beat the old scorecard (Champion) in terms of profitability, as the increase in sales did not outweigh the increase in bad debt. See the below table for more details.Profit scenarios

 Initial Scenario (Champion)Challenger AChallenger B
Increase in Accounts0%+8%+17%
# Accounts100108117
Average Loan size$5 000$4,800$4,700
% Change in average loan size0%-4%-6%
Total Disbursed$500 000$518 400$549 900
Revenue$50 000$51 840$54 990
Fixed Cost$6 000$6 000$6 000
Fixed cost per Account$60$55.6$51.3
Bad Debt increase0%5%7%
Actual Bad Debt5%5.3%5.4%
Bad debt cost$25 000$27 216$29 420
Profit$19 000$18 624$19 570
% Profit change -2%3%
Profit per Customer$190$172$167

Let us take an alternative scenario (Challenger B) where instead of an 8% increase, the new model results in a 17% increase in the customer base.

Once again, the new customers are risker and so average loan amounts are lower, but the higher sales numbers more than make up for this and total revenue grows significantly to $54 490 (vs $50 000 originally). These riskier customers also increase the cost of collections and bad debt rates, with total bad debt costs peaking at $29 420. This however isn’t enough to spoil the party as the change in revenue offsets the increase to result in 3% more profit overall.

In this scenario both James and Gordon have cause to celebrate as their joint KPI of increased profit has been achieved and the new scorecard (Challenger B) is deemed to be a success.

By refining the scorecard that is used to determine the acceptable level of risk, the heavy reliance on increased sales numbers in order to achieve a positive increase in profits is lessened. Gains can be made if Gordon and the credit risk team improve the scorecard’s performance with regards to lower risk accounts and if James and the sales department refine their sales approach.

Using a profit model approach allows organisations to refocus their strategy and to gain the maximum potential profit from their new and existing customer base. Considering the fact that profitability is the ultimate KPI for any business, using a profit model over more traditional KPI’s is an obvious choice.

*Note: all above numbers are not based on an actual case study. To find out more about profit models and their application please contact us and we will be happy to discuss it with you in more detail.