Realization vs Profitability: What You Need To Know
Published on Saturday, September 28, 2019
Business execs need to understand the relationship between revenue realization and profitability in order to increase their bottom line. In this article, we will examine the relationship between these two concepts to see how they tie into your business’s overall financial health. Read on to learn more.
If you want to understand or improve on a certain financial metric, you first have to understand and measure that metric. Knowing how much revenue your company actually realizes on a month-per-month basis will give you the insight you need to improve your revenue growth and, ultimately, your profitability.
What is Revenue Realization?
In the ideal world, we would want to assume we recognize 100% of the revenue related to the deals we sell. Unfortunately, due to a myriad of reasons, this isn’t always the case.
Your revenue realization rate shows how much revenue you recognized compared to how much you sold and expected to recognize at the time of closing a deal or transaction. This rate is expressed as a ratio and is a valuable metric that tells you how well you manage to translate hours worked on accounts into revenue.
When your realization rate is quite low it means you aren’t converting all of what you sold into revenue, which essentially means you are leaving money on the table.
Calculating Your Revenue Realization Rate
Let’s start at the beginning. The formula for revenue realization rate is:
Realization Rate = Actual Revenue / Expected Revenue
The actual revenue is the amount you have recognized for delivering your products or services. The expected revenue is the amount you should be seeing. You may be wondering how these two numbers can be different from each other. Well, there are multiple reasons there can be discrepancies between the two.
For instance, a manufacturing company supplying parts to another business may not actually ship the same volume of parts that were originally priced and estimated in an agreement. Vendor or production delays or lower demand on the customer’s side could be the culprit.
Consider another example: A SaaS company sells a new software subscription service to another company that is for $1,000 a month for an annual subscription starting in January. During the activation process for this new software, a critical bug is found, and the software cannot be activated until the bug is fixed.
The original booking was for $12,000 in Annual Recurring Revenue for that calendar year, but due to this delay in delivery, the revenue slips by two months until the software is corrected, resulting in a $2,000 ($1,000 x 2 months) shortfall between what was expected for the year ($12,000) and what actually was realized in that year ($10,000).
The resulting Revenue Realization Rate for this deal was 83.33% ($10,000 divided by $12,000).
Where a realization rate only measures the revenue side of your financials, profitability can take other factors into account, like expenses and overhead
Like with revenue realization, knowing exactly what profitability entails and how you can measure it is crucial if you want your company to prosper. Here’s what you need to know about profitability.
What is Profitability?
Your company’s profitability is your net profit margin which equals your revenue minus your service costs, less other overhead and expenses
Of course, companies always track overall profitability to determine overall company health, but that won’t give you the detailed information you need to differentiate between what customers are the most profitable. For this reason, looking at each customer’s profitability and analyzing it on its own will be able to guide you in the right direction.
As mentioned above, the simple version of profitability can be calculated by subtracting service costs from a specific customer’s revenue.
Sometimes, this is termed as a customer profitability analysis (CPA) and is calculated using the annual profit produced per individual customer and the total time that the customer has spent using your business’s services.
To calculate the annual profit you subtract expenses you incurred to serve the customer from the revenue that you generated through that customer. In the revenue, you should consider recurring revenue, any upgrades, and additions to their subscription.
For the expenses, you should consider how much you spent on customer services, maintenance of their services and of the customer service team, and operational expenses. Once you have calculated the annual profit, then you can calculate the CPA. To do this, you multiply the annual profit by the number of years the customer has been with your company.
The Importance of Both Performance Metrics
If your realization rate is poor and you are only recognizing a portion of what you sell.T
Which metric is more valuable? The clear and simple answer is that both profitability and revenue realization rates are excellent performance metrics. Although they can appear to sometimes be unrelated since it is possible for one to be high and the other quite low, together they serve as the best financial indicator.
While a high profitability rate is great overall, the realization rate tells us about our earning potential, which is critical for future revenue growth. In fact, maximizing revenue realization is crucial to preserving profitability.
Revenue Realization and Profitability Applications
By cutting prices, your company is actually sending the message that you aren’t confident in the value of your work. So instead of attracting customers with reasonable prices, you could be scaring them away by creating unnecessary doubts about the quality of your product or services.
Through effective communication with customers and by valuing your own work, you can enhance realization so that your customers value you too. Maintaining price reductions because of late communication regarding price increases should be avoided if possible. Secondly, if a customer asks for a discount, it is important to remember that it is okay to say no.
Increasing your prices while maintaining your current realization rate is not necessarily the best strategy. However, boosting realization may have a bigger impact on your overall bottom line than increasing prices by the same percentage and maintaining your current realization rate.
By improving your revenue realization process, you could see increased profitability, provide improved standards for sales, operations and billing and improve collaboration across departments.
Understanding the relationship between revenue realization and profitability helps you to effectively increase your company’s bottom line. Remember, by sticking up for your services and by implementing proper communication practices across sales, operations and finance, you could increase your realization rate and boost your overall profits.
In the end, you should run your company like the efficient business you want it to be.