Are a Few Money-Losing Products Stealing Your Profit?

Just a few money-losing products can wipe out a lot of bottom-line profit. Is it happening to you? The only way to know for sure is to do the analysis. This article will show you how.

First, here are the formulas that you’ll need:

Now, it’s just a matter of three easy steps.

Step 1: For each product or service, determine gross profit per unit and gross margin per unit.

Gross profit per unit is the incremental profit earned per unit sold, as described in the following formula:

The revenue per unit is the revenue earned from a single unit sold. The expense or cost considered is that expense or cost that is incurred directly and solely due to the additional unit sold -- also referred to as both the direct cost, and as the cost of goods sold. Such costs may include the cost of materials (tangible or otherwise), labor, or both. Such cost ignores indirect costs (also referred to as fixed costs) such as facilities, non-direct labor (which is commonly referred to as sales, general and administrative expense), insurance, office supplies, etc.

The gross margin is simply an expression of the relationship between direct revenue and direct cost, expressed as a percentage and calculated using the following simple formula:

To illustrate, consider XYZ Company, a reseller of industrial filtration units. They calculate their direct cost per unit at $500. The $500 is the sum total of all direct costs that are incurred to deliver a single sold unit, such as the filtration unit itself, which is purchased from an outside vendor, and the cost of the labor paid to XYZ employees that perform very light machining and assembly on each unit. They sell each unit for $1,000. XYZ calculates their gross profit and gross profit margin on this product line as follows:

Again, XYZ incurs the $500 direct cost only when a unit is sold. In practice, XYZ anticipates orders and builds units in advance, but the costing and calculation of gross profit remain unchanged.

Step 2: Determine the Fixed Costs Associated with the Product Line.

Fixed costs are incurred by simply maintaining the capability to produce the product and product line and to market and sell the products in the marketplace. Such costs do not increase with each additional unit produced or sold, and they typically include indirect labor and overhead costs such as rent, utilities, machinery, equipment, bookkeeping, licenses, permits and taxes.

XYZ Company calculates its annual fixed costs associated with its industrial filtration product line as follows:

Step 3: Calculate the Profitability of the Product Line.

With Step 1 and Step 2 completed above, Step 3 is simple. Here is the formula:

If your company has only one product or service, then the profitability of your product line should be identical to the profitability of your business, as in the pretax profit on your company’s annual income statement. If this is the case, then organizing your income statement in a way that will clearly break out variable and fixed costs is recommended. But if you have multiple products, this analysis is useful to determine what products are contributing to your bottom line.

XYZ Company sells 150 units of the subject product line per year. As calculated above, its gross profit per unit is $500. Therefore, the total annual gross profit from the product line is $75,000. By subtracting the $40,000 of fixed costs required to be incurred annually to maintain the product line, we find that the industrial filter line adds $35,000 to the bottom line each year. The calculation is as follows:

To illustrate the impact that money-losing products and services can have on a company’s overall profitability, let’s look at a consulting firm that has 20 types of consulting projects. Quantum Consulting spent a year tracking the labor hours and direct costs required to deliver each of its project types. Quantum also knows the income that each type of job brings. Here are the simplified 2006 data:

• Total annual revenue was $1,000,000
• Each of the 20 project types generated $50,000 in revenue
• Fixed overhead costs were, and will continue to be, $205,000 per year
• Operating profit was a negative $5,000

When each project type was analyzed for 2006, it revealed that two of the 20 project types lost money. In fact, the money-losing two together cost $50,000 more than the $50,000 in income they generated (i.e., together the two products brought in $100,000, cost $150,000 and therefore lost $50,000). If Quantum were to eliminate these offerings altogether and the labor associated with the delivery of such projects, revenues would decline to $900,000, but operating profit would increase $50,000 to $45,000. Here is the comparison.

By simply eliminating 10% (two of the 20) of the project types and 10% of overall revenue, Quantum becomes a profitable company at a respectable operating profit margin of 5%. If fixed expenses could also be reduced, then the bottom line would rise dollar-for-dollar and the operating profit margin would increase sharply.

Now, another alternative would be for Quantum to find a way to keep the two money-losing offerings but make them profitable. The average gross profit of the 18 profitable offerings is 28%. If we assume that the two losers could also earn 28% or $14,000 gross profit each, then Quantum’s Proforma Income Statement would look like this:

Now, by simply analyzing the profitability of each product and turning around the two money-losers, Quantum’s bottom line has increased to a respectable 7.5% profit margin. And that, compared to a net loss, is all the difference in the world.

A small number of money-losing products or services can have a devastating impact on the overall profitability of a company. Quantum lost money in 2006 though 90% of its products were profitable!

The lesson: Analyze your per-product profitability. Have these reports produced regularly, and then use the information to create profitability across your entire product line. The impact of losers is too great to ignore.

Setting Hurdle Rates for Profitability

As the saying goes, “There is no such thing as a free lunch.” Similarly, companies do not become highly profitable without significant effort to make it so. Coupled with the fact that profitable delivery of products or services is the only way an owner can further his or her other company-supported goals or objectives, every business owner should make profitability the first and highest objective. As such, every business owner should set hurdle rates for the minimum profitability allowable for any product or service offering.

For example, well-managed retailers assign a value to each inch of shelf space, then they measure the gross profit produced by each item. Items that do not meet the required gross profit contribution are dumped for ones that will.

The Power of the Gross Profit Margin

The profitability of a business is very sensitive to its gross profit margin, because the gross profit must cover all of the fixed operating costs of the business. As such, it is important to recognize the effect that changes in gross profit margins can have on operating profit when purchasing and pricing decisions are being made.

To illustrate, if a company has a 40% gross profit margin (i.e., cost of sales takes 60% of revenue) and a 10% operating profit margin (also referred to as pretax profit), a 10% increase in the cost of goods sold will reduce operating profit by 60%. Here’s the math with percentages:

The lesson: Gross profit and gross profit margins must be protected. Keep this in mind every day. Fight to obtain ever lower pricing from your vendors and find ways to win sales without reducing prices.

Checking Contribution to Fixed Overhead Expenses

Before an unprofitable product line is eliminated, be sure that you have accurately estimated indirect expenses that can be eliminated if the line is killed. If fixed-expense savings are overestimated, the result could be lower overall company profitability.

To illustrate, let’s look at Rader Corp. Rader has five product lines. In 2005, four products produced $200,000 each in annual gross profit and one produced just $50,000 in annual gross profit. As such, gross profit was $850,000 in 2005. Rader’s operating costs were $750,000 in 2005 and its net income was $100,000. At year-end, Rader’s CFO made a pitch to Sam Rader, the owner, making a case for eliminating the fifth product line. The CFO estimated that $100,000 of fixed overhead costs could be eliminated along with the weak line. Here is the 2005 performance, the CFO’s pro forma for 2006, and the actual 2006 performance:

On paper, the CFO’s idea looked great. But the staffing cuts were delayed and then never made, and the extra facility space was not leased to a third party as projected. The result was that the fixed costs remained unchanged from 2005, but the marginal product, the one that contributed only $50,000 in gross profit in 2005, was not available to help cover overhead costs. Unfortunately, most of the year went by without Rader management realizing its mistake. But in the fall, it had to decide whether to: (1) reduce fixed operating expenses as planned, or (2) attempt to replace the lost gross profit by selling more of the remaining four product lines, or (3) add a new product that might be able to contribute more gross profit, or (4) reintroduce the eliminated product.

Sam Rader decided to reintroduce the eliminated product in a “platinum package” that was expected to perform up to par with its peers. If it does, the 2007 income statement will look as follows:

Assessing Return on Marketing Expenditures

For most businesses, marketing and advertising expenditures are incurred to increase sales of already-established products. As such, the expenditure of a particular advertising or marketing program is justified by the additional sales and resulting gross profit that it generates. To assess the return on an expenditure of this type, simply calculate the number of sales that result, or are expected to result, multiply this number by the gross profit per unit, then subtract the cost of the investment made or required. Finally, divide the result by the investment made or required.

For example, Vintage Wineries spent $100,000 on a series of ads in the northeastern United States that management estimated would generate 40,000 additional bottles of wine sold at an average gross profit of $3 per bottle. To assess the profitability of the expenditure, the following formula is applied:

In this example, Vintage obtained a nice return on its investment of 20%.

Every business owner should consider the return on investment of expenditures, using an analysis similar to the above. Certainly, Vintage might also consider the present value of future purchases by customers that try their product during the analyzed period. Regardless, a process of expenditure justification should be applied to investments made in an effort to either project returns or assess actual returns.

Assessing the Attractiveness of Proposed Products or Services

You are considering adding a new product. To run the numbers, you need the following:

Annual fixed costs -- Costs that do not change with volume changes such as rent, utilities, insurance, or the annual cost of furniture, fixtures and equipment.

Variable Cost Per Unit -- The direct cost of producing a single unit.

Net Sale Price Per Unit -- The income per unit after any sales commission.

# Of Units Estimated to Be Sold -- The number of products or services expected to be sold during the analyzed period.

The process for assessing the potential profitability of a new product or service is virtually identical to the process for assessing a marketing expenditure -- both are investments. To further illustrate this type of analysis, let’s consider an auto detail business that is considering adding window tinting.

Otto’s Auto Detail has the space available in its existing facility. The estimate of fixed and variable expenses is as follows:

Now, Otto plans to sell each window tint job for $150 -- the market rate in his area. In addition, he estimates that he can sell and deliver one a day, on average. He calculates his estimated profit as follows:

To better understand his downside, Otto calculated his breakeven as follows:

He went further and calculated the return on investment (ROI) that he would receive if he hits his sales and cost estimates. To do so, he had to adjust his numbers a bit. The total amount that he will invest at the beginning of year one is $11,800 ($4,000 in fixed assets, $7,000 in advertising and $800 in utility expenses). His annual profit is estimated to be $24,600 Ð $1,000 higher than the profit estimate used above because, in the ROI analysis, we subtracted from expense the $1,000 amortization of the original $4,000 investment in fixed equipment and tools. His calculations are as follows.

Otto has a very nice investment at hand with a 209% annual Return on Investment.

What to Do About the One-Time Costs Incurred When a New Product Line Is Added

As we have discussed, to “run the numbers” one must calculate the annual fixed expense and the variable revenue, expense and resulting gross profit for each unit sold. But what about one-time costs that may have to be incurred when the decision is made to begin providing a new product or service, such as the purchase of real property, machinery or equipment?

The answer is that the cost of these items will be a fixed cost, as the cost of these items is not affected by unit volume -- at least not within certain capacity ranges. In addition, these up-front costs must be turned into an annual cost. This can be accomplished easily by leasing the equipment rather than buying it, or by using the annual debt service requirement of the capital equipment. If the expenditure is made out of internal funds, simply divide the total amount by either the life of the capital items or the desired payback period in years. If the equipment is financed and a down payment is made, the down payment amount should be treated similarly.

For example, if the equipment is expected to last 10 years, but the owner wants a five-year payback, the down payment would be amortized over five years. As such, one-fifth of the down payment amount would be added to the annual fixed costs to arrive at the total.

The Make-or-Buy Decision

Considering making a part internally that you currently outsource? You are facing what is referred to as a “make or buy” decision. To run the numbers you simply need to estimate annual fixed cost that will be incurred by making the product internally, and the per- unit cost. With these data, you can calculate your breakeven point and the profits to be earned at your current or projected sales levels. This will require a slight adaptation of the typical breakeven equation. In the make-or-buy decision, the “breakeven” point is the point at which the cost of making the parts internally equals the cost of buying them outside. Therefore, the equation is as follows:

To illustrate, let’s assume that your company, ABC, now purchases 225,000 units annually from an outside source at an average cost of $0.25 per unit. Your calculations say that your per-unit variable cost will be $0.20 per unit at the same annual volume, and that an annual cost of $10,000 will have to be incurred to rent the required machine and staff it part-time.

The breakeven point for the proposed project is as follows:

Therefore, we see that we cover our fixed costs and “break even” at 200,000 units. If our projected usage requirement is greater than 200,000 units, money will be saved by making the component in-house. If our usage requirement is less than 200,000 units per year, it will be cheaper for us to continue buying the parts from the vendor. At 225,000 units, our annual saving is calculated as follows:

ABC Company would save $1,150 by making the part internally as opposed to buying the parts from its vendor at the 225,000-unit level.