Profit Velocity
Profit velocity, also known as margin velocity, is a financial metric that measures the speed at which a company generates its gross profits. It takes into account not just the profit margin, but also the total time required to produce and sell the products or services.
It is a useful concept in industries where capital investments, production times, and inventory turnovers can greatly vary between products. By assessing the speed at which each product generates profit, companies can make more informed decisions about where to focus their production and marketing efforts.
For example, a product with a high profit margin but a slow turnover might generate less overall profit over time than a product with a thinner margin but a fast turnover. By focusing more on the fast-turnover product, a company might be able to improve its overall profitability. This concept becomes even more important in scenarios where capital is tied up in equipment or inventory, as it highlights the importance of capital efficiency and return on investment.
The basic formula to calculate profit velocity is:
Profit Velocity = Gross Profit / Total Time
Where:
- Gross Profit is the total revenue from sales minus the cost of those sales.
- Total Time is the time taken to produce and sell the products.
Please note that the specific calculations can vary, and businesses often adjust them to better reflect their operations and their industry.
Example of Profit Velocity
Let’s consider an example with a manufacturer, “WidgetCo,” that produces two types of widgets: Widget A and Widget B.
Widget A has a profit margin of $50 per unit and takes 1 day to produce and sell. Widget B, on the other hand, has a higher profit margin of $100 per unit but takes 3 days to produce and sell.
Let’s calculate the profit velocity of both products:
Profit Velocity of Widget A:
= Gross Profit / Total Time
= $50 / 1 day
= $50 per day
Profit Velocity of Widget B:
= Gross Profit / Total Time
= $100 / 3 days
= $33.33 per day
Despite Widget B having a higher profit margin per unit, the profit velocity of Widget A is higher. This means WidgetCo generates profits faster with Widget A compared to Widget B due to the shorter production and sales cycle.
Therefore, if WidgetCo has limited production capacity, it might choose to produce more of Widget A, as it generates profits more quickly, improving the company’s cash flow and overall profitability. This illustrates how profit velocity can be a useful metric for making strategic business decisions.
