Why are the profit margins decreasing when the revenues are increasing? A pragmatic product profitability analysis can help the company to achieve a profitable growth, without draining too many resources.
Why does the profit margin decrease when revenues increase? How can product calculations signal profitability, while the company is making a negative profit? This article offers six tips on how a product profitability analysis can help your company achieve profitable growth, without draining too many resources.
Product profitability analysis is in simple terms about understanding which revenues a product contributes with, and which costs it drives. Our experience shows that a successful product profitability analysis helps the company to a profitable growth in three ways:
Action based on a common view of how profitable the products are
Decision support for strategic direction – growth, price, range or sales channel
Tools to identify concrete actions to reduce costs and/or increase revenues
Six tips on how a product profitability analysis can help your company achieve profitable growth
1. LOOK BEYOND THE GROSS MARGIN FOR RELEVANCE
In order to have a relevant analysis to base decisions or identify concrete actions from, we need to understand the profitability beyond the gross margin.
All costs then need to be linked to the product, i.e. allocated to the product. Examples of costs that are often forgotten are depreciation (including wastage) and returns.
2. OBJECTIVE ALLOCATION GIVES A FAIR PICTURE
A cost allocation rule must be logical and independent of preconceptions. It should be agreed with and agreed by key stakeholders before the results of the analysis are finalised and presented. It defeats the whole purpose of a profitability analysis if allocation rules are tailored to the profitability outcome a stakeholder wishes to see. It will then only become a confirmation of existing “truths”.
3. PRAGMATIC APPROACH
We have found that an analysis of gross margin alone does not provide sufficient answers as to how profitable a product is. On the other hand, a full-scale ABC analysis (Activity Based Costing) often provides limited marginal benefit.
The purpose of a pragmatic approach is to maximize the return on investment, i.e. time and resources to design and continuously use an analysis model.
Below we list three examples of what characterizes a pragmatic profitability analysis.
4. SELECTIVE DEEP DIVING IN ORDER TO ACT
An analysis should lead to concrete results and must therefore be deep enough to act on. But instead of a full-scale ABC calculation, we advocate that deep diving be done if and where necessary. For example, in a B2B company, a breakdown in customer profitability is often needed to renegotiate price or make a decision to change pricing strategy for a product. For a manufacturing company, a detailed cost-effectiveness analysis may be needed, in order to initiate the right savings measures.
5. INTERNAL BENCHMARK COMPARES APPLES TO APPLES
Internal benchmarking of product profitability between countries, regions, stores, customers or plants provides a controlled opportunity to compare and learn from the best product profitability within the company.
External benchmarks are certainly popular, but it is often difficult to know whether apples are really being compared to apples. In addition, the opportunity to compare externally is often lost when the analysis is deepened.
6. “MAKE IT STICK” FOR CONTINUOUS IMPROVEMENT
A product profitability analysis can have a value as a one-off event, as a decision support for e.g. a product range strategy. But to understand the impact of such a decision, and to achieve continuous improvement, the model behind the analysis should be built in such an automated and educational way that it is reusable. Take advantage of existing analytical tools such as Power BI, QlickView, etc. Combined with clear governance (who, how, what), the company will have a powerful tool for continuous improvement.
A product profitability analysis that goes beyond gross margin and is deep enough but pragmatic enough to be actionable, allows the company to take concrete actions and make strategic decisions towards profitable growth. Moreover, a reusable analysis model, where allocation rules are logical and internal benchmarking provides motivation, creates the necessary actionability to take the results all the way to the books.
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