Profit planning is the set of actions taken to achieve a targeted profit level. These actions involve the development of an interlocking set of budgets that roll up into a master budget. The management team adjusts the information in this set of budgets to arrive at the combination of actions needed to arrive at the targeted profit level. The planning process may involve a significant amount of what-if analysis, to see what happens to projected profits in different scenarios.
When handled correctly and with an emphasis on making realistic estimates, profit planning can pinpoint those specific actions that must be taken to arrive at a profit goal. For example:
- Increase the investment in new product development in order to increase new product sales
- Expand the regions within which existing products are sold
- Target areas of declining sales where it can make the most sense to eliminate products or cut costs
- Take steps to mitigate risks that may otherwise result in unusually large losses
- Target bottleneck operations to increase the productive capacity of the business
The plan may result in operational and financial issues that must be addressed. For example, it may be necessary to increase the headcount in certain areas, which in turn will require more office space and computer equipment. Further, an expansion of the business may call for more financing, either in the form of debt or equity.
Profit planning is only effective if the management team follows through on the action items stated in the plan. All too often, profit planning is merely an annual exercise that management engages in, but does not follow through on. Also, profit planning must be revisited whenever there is a significant change in business conditions that invalidates the results of the old plan. Otherwise, management will continue to follow old directives that have no relevance in the new environment.