Strategies to improve profitability ratios
Strategies to Improve Profitability Ratios
Identifying that profitability ratios are weak or declining is the starting point for financial management — not the conclusion. The more demanding task is to understand which lever to pull: raise revenue, cut direct costs, reduce overheads, or deploy capital more efficiently. Because each profitability ratio measures a different dimension, the appropriate strategy depends on which ratio is underperforming and why.
Strategies to improve gross profit margin
Since GPM = gross profit / revenue, it can be improved either by increasing revenue without proportionally increasing COGS, or by reducing COGS without proportionally reducing revenue.
Increase selling prices. If demand is relatively price-inelastic, raising prices increases revenue without a corresponding rise in COGS, improving GPM directly. However, in competitive markets or for price-sensitive products, a price rise may reduce volume sufficiently to lower total gross profit despite the higher margin per unit.
Reduce cost of goods sold. Renegotiating supplier contracts, sourcing cheaper raw materials, improving production efficiency, or switching to lower-cost inputs can all reduce COGS. The risk is that cheaper inputs may compromise product quality, damaging brand reputation and ultimately reducing revenue. Economies of scale achieved through higher production volumes can also reduce the unit cost of goods sold.
Change the product or sales mix. If a business sells products with different GPMs, shifting sales towards higher-margin products — through targeted marketing, promotional pricing, or discontinuing low-margin lines — can improve the overall GPM without changing any individual price or cost.
Strategies to improve profit margin
Since profit margin = PBIT / revenue, it can be improved by either improving GPM (addressed above) or reducing operating expenses (overheads).
Reduce overhead costs. Renegotiating rent, reducing administrative headcount, cutting discretionary marketing spend, or consolidating premises can lower fixed and semi-variable overhead costs. The risk is that overhead cuts may reduce the capability of the business — fewer staff may mean slower customer service; reduced marketing may limit future revenue growth.
Improve operational efficiency. Automating repetitive processes, adopting lean production principles, and reducing waste all lower the cost per unit of output without necessarily cutting inputs. This improves the overhead burden ratio without the quality or capability risks associated with blunt cost-cutting.
Strategies to improve ROCE
Since ROCE = PBIT / capital employed, it can be improved either by increasing PBIT (addressed above) or by reducing capital employed without sacrificing profit.
Reduce capital employed. Repaying long-term debt reduces non-current liabilities, lowering capital employed. Selling surplus non-current assets or returning excess equity to shareholders through share buybacks or special dividends also reduces capital employed. If PBIT is maintained, ROCE rises. However, reducing capital employed excessively can leave the business under-resourced for future investment.
Improve asset utilisation. If existing capital generates more revenue and profit — through higher capacity utilisation, better asset management, or more productive use of property — ROCE improves without reducing the capital base. This is a more sustainable approach than simply shrinking capital employed.
| Strategy | Ratio directly improved | Key risk or trade-off |
|---|---|---|
| Raise selling prices | GPM, profit margin, ROCE | May reduce volume if demand is price-elastic; could lose market share |
| Reduce COGS (cheaper inputs) | GPM, profit margin, ROCE | Risk of quality reduction; may damage brand reputation |
| Shift sales mix to higher-margin products | GPM, profit margin, ROCE | Requires effective marketing; some product lines may be discontinued |
| Cut overheads | Profit margin, ROCE | May reduce business capability; staff morale and service quality at risk |
| Improve operational efficiency | Profit margin, ROCE | Requires upfront investment in automation or process redesign |
| Reduce capital employed | ROCE | May leave business under-resourced; asset sales are one-off |
| Improve asset utilisation | ROCE | May require investment in training, systems, or capacity management |
Following the decline in all three profitability ratios identified in Section 3.5a (GPM: 50% to 45%; profit margin: 18% to 13%; ROCE: 20% to 15%), the board of Canvey Ridge Textiles plc considers three strategic responses.
First, it explores raising prices by 8% on its premium product range, arguing that brand loyalty provides some price inelasticity. The risk is losing price-sensitive customers to lower-cost competitors in an increasingly crowded market.
Second, it reviews its supplier contracts for synthetic fabrics and identifies that switching to a new supplier could reduce COGS by approximately £180,000 per year — but initial quality testing and transitional risks must be managed carefully to protect brand integrity.
Third, the board considers selling an underutilised warehouse facility (book value £420,000) and leasing equivalent storage space instead. This would reduce capital employed and improve ROCE arithmetically — but the ongoing lease payments would increase overheads, simultaneously depressing profit margin. The directors conclude that no single strategy is without a trade-off, and that a combined approach — moderate price increases on premium lines plus supplier renegotiation — is preferable to a single large intervention.
Key Takeaways
- Improving GPM requires either raising revenue without proportionally increasing COGS, or reducing COGS without proportionally reducing revenue.
- Improving profit margin requires either improving GPM or reducing operating overheads — or both.
- Improving ROCE requires either increasing PBIT or reducing capital employed — ideally both simultaneously.
- Every strategy to improve profitability involves a trade-off: cheaper inputs risk quality; price rises risk volume; cost cuts risk capability; reducing capital employed risks under-investment.
- The most appropriate strategy depends on which ratio is underperforming, the cause of underperformance, and the competitive context — there is no single correct answer.