Product and customer profitability analysis
How to know which products, services, and customers are hurting your profits without you even noticing.
If you’re looking for a quick path to higher profits and possibly less work, look no further than a customer and product or service profitability analysis. You might wonder why it’s necessary given that you track these numbers already (and if you aren’t, you should be). The truth is, most reporting systems aren’t set up to give you the real information. What you see is not the whole story.
There are costs associated with products, services, and customers that are buried in Operating Costs which is below the Gross Margin line. To see the real profitability you need to find these hidden costs and tie them directly to the relevant product, service, and customer.
In effect, you’re calculating the “contribution margin” which is the % of the revenue that each one is contributing to fixed overhead, the mostly fixed costs that vary only slightly with volume. If your fixed overhead is 15% of Sales then you want each product, service, and customer to generate at least 15% PLUS your target profit margin. If that’s 10% then the contribution margin you’re aiming for is 25% or higher. Anything between 25% and 15% is cutting into profits and anything under 15% means the product, service, or customer isn’t contributing its fair share to overhead. And of course, when the contribution margin is negative you’re losing money on every sale. I love those because it means you can stop selling the product, service, and/or customer and actually make more money. But in many cases when you know your contribution margins are low you’ll begin adjusting price and cost to move closer to what you need.
Cost of Goods Sold & Operating Costs
Now let’s take a closer look. Most companies think that a product’s Gross Margin tells you everything because it’s what’s leftover after accounting for direct product costs and the associated overhead. But there are other product-related costs that are not in Cost of Goods Sold. They’re hiding in Operating Costs. For example, there are R&D costs, product development costs, product promotion costs, licensing costs, even packaging and shipping costs, etc. Some products have several. A good way to identify them is to look at what costs would go away if you didn’t have that product and never developed it in the first place. In some cases these costs are small but in my experience, most companies have a good number of products where these costs are significant.
The same happens, perhaps to a lesser extent, in service companies where many don’t even start with a proper Gross Margin number because they don’t separate out the direct cost of labor and materials into what’s called Cost of Sales. Instead, they include them with all other payroll and expenses in Operating Costs. If that’s you then your first step is to get it fixed. But assuming you have a proper Gross Margin number you’ll want to dig into operating costs and see what’s in there that’s associated directly with each service you provide. Split out the services so you can isolate the gross margin and any operating costs associated directly with each one.
Make sure you also look at customer profitability. For example, there are customers who are hard to work with, who require extra attention, sales trips, samples, rush shipping and God knows what else. Those expenses are usually shown in Operating Costs. To get to real customer profitability, list the direct costs of serving each customer based on the specific mix of products and services they buy and then allocate (as best you can), for each customer individually, whatever you see in Operating Costs that relate directly to them.
I assure you that this exercise will reveal surprises. Once you have the facts, you can make whatever adjustments seem appropriate. And resist the temptation to hold on to a losing product, service, or customer. It’s easy to rationalize having just a few but why settle for that. And it’s a slippery slope. Bite the bullet and protect your margins. Maybe you’ll end up doing less business for a while, but your profitability and sometimes even total profits will go up. And with that, you’ll be making more money with less work.