by Product profitability analysis is the process of linking a company’s overall profit back to the profit of a specific product. A company’s overall profit is the money they have left at the end of an accounting period after subtracting total costs from total revenue.
Profit is the amount of revenue that remains after accounting for all expenses, debts, and other costs. So, product profitability, then, refers to how much money a product makes minus what it costs to build, sell, and support it.
Profit is what you have left over after accounting for all expenses and costs of a product. Let’s say your company makes office staplers of all shapes and sizes. After all expenses, you clear 18%. That means that you clear 18 cents per dollar of revenue.
Product profitability analysis ties costs back to a product and matches revenues to that specific product. When you run the analysis, you will likely discover an interesting phenomenon: 80% of sales come from 20% of your customers or products.
It doesn’t mean we stop focusing on the products that don’t earn us money, in fact, we can use product profitability analysis on those products to determine next steps for improving profit margins on those products.
Remember that profitability analysis ties revenues and costs to each product. We’ll continue with our Red Line stapler product. The Red Line is only one product in a line of many. We’ll need to separate all revenue and expenses for this particular product in order to analyze our profitability.
The product team is responsible for learning key details about their market and users, to help them build a solution that finds a product-market fit. Some of these strategic details include:
- The interest and demand levels of the potential user base.
- The size of the total addressable market for a product.
- The right way to price the product, to maximize both market share and profit.
- The resources (measured in personnel, time, and budget) it will take to build the product.
Determining true cost
There are many factors to consider when calculating the true cost to produce an item. To understand the true cost of producing an item, every fixed and variable cost that exists needs to be taken into consideration. Some costs to remember to factor into the overall costs are:
- Utilities
- Inventory
- Property leases
- Loan repayments
- Equipment leases
- Employee wages
Other factors that accountants should write into the profit margin are:
- Shrinkage (stolen items)
- Unexpected shortages
- Markdowns
- Employee discounts
- Damaged inventory
- Shipping
Testing the market
It’s important to know the market price of an item to decide whether customers are willing to pay enough for the item to make it profitable. This applies to items already in production and to new items a business is thinking about producing. To effectively gauge the market price for an item, there are many considerations, like:
- Retail and online prices
- Competitor prices
- Product research
- Economic trends
- Market saturation
Making assessments
Constant pricing assessments on a monthly, weekly or even daily basis keep the company engaged and informed about which products are meeting profit expectations and which ones aren’t. One common practice is completing monthly product profitability assessments and placing all products into categories like “growth,” “core” and “probation.” Professionals give items in the probation category an action plan to improve their sales. If sales don’t improve, the company may phase out this item.
Understanding margins
Profit margins are the difference between the cost of producing items and total revenue for those items. Anything a company can do to reduce the cost of producing an item raises the revenue for that item. Some ways to do this include:
- Reducing overhead
- Streamlining the checkout process
- Becoming more energy efficient
- Reducing shipping costs
- Reducing labor costs
Keeping detailed documentation
Detailed documentation about the profitability of each product prevents a company from keeping unprofitable products longer than necessary. Collecting documentation from the marketing team, sales team and operations teams helps clarify what margin targets need to be in order for the product to remain viable. This also allows professionals to quickly identify downward trends. Additionally, detailed documentation helps with the creation of logical strategies, timely reviews and measurable targets.
Looking at external factors
External factors can impact opportunities and concerns around the profitability of products. The sales, marketing and operations teams can collaborate to assess the impact on each product, take immediate actionable steps or do long-term planning with an understanding of relevant external factors. Some external factors that impact product profitability include:
- Expected market changes
- Competition for the product
- Demand increases or decreases
- Shelf space at stores
- Spinoff products
Subtract all direct and direct costs from total revenue.
After you’ve tallied up all direct and indirect costs, you can now subtract that number from your product revenue. If what remains is a positive number, congratulations: You have a profitable product.
