Product Profitability

DefinitionProduct Profitability

• Product profitability, simply defined, is the difference between the revenues earned from, and the total costs associated with, a product over a specified period of time.

Product Profitability Analysis

• Product profitability analysis requires that all relevant costs are traced to products and then matched to their corresponding revenues. Such analysis can then inform a wide range of management decisions such as product pricing and product portfolio analysis.

Achieving Product Profitability

• Looking beyond revenue and gross margins to uncover hidden profits and losses.

• By factoring in the real costs associated with each product, you are able to make adjustments.

• Requires a level of accuracy and granularity.

• Requires accurate data capture and analysis at every point.

• Modelling your business processes so that you are able to make good decisions that lead to profitable adjustments.

Benefits of Product Profitability

• A clear view of which products and product mixes are cost effective. In addition to

managing current results the analysis can refine product pricing strategies

• Single source of product data that can be utilized across the enterprise to facilitate

a true common reporting platform for product profitability

• Real-time analytic capability of what discounts can be given to customers while

accurately assessing the impact on margins to ensure margin protection

• Provide ‘what-if’ analysis for changes in the cost base allowing for re-forecasting

and preparation for changeable commodity markets

• Identify areas of growth in margin not just in revenue and accurately forecast

profitability of new products and proposed product mixes

Profit Parameters

• Gross Margin = Revenue – Cost of goods sold.

All costs are manufacturing costs. Some of them are fixed costs.

• Contribution margin = Revenue – Variable costs

Some variable costs are manufacturing costs, but some may be non-

manufacturing costs. None are fixed costs.

• Gross margin percent = Gross margin/Revenue

• Contribution margin percent = Contribution margin/Revenue

Profit Accounting Model

• The fundamental accounting equation

• Profit = Revenues – Costs

• Revenue = SP * units sold

» SP = selling price

• Costs = FC + VC(units manufactured)

» FC = fixed cost

» VC = unit variable costs.

• We are assuming that units manufactured equal units sold

Cost-Volume-Profit Analysis

• Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold.

• Total costs can be divided into a fixed component and a component that is variable with respect to the level of output.

Case Study – Cost-Volume-Profit Analysis

• A Company manufactures and sells pens. Present sales output is 5,000,000 per year at a selling price of Rs.5 per unit. Fixed costs are Rs.9,000,000 per year. Variable costs are Rs.2 per unit.

Product Sales Data Year 1 Year 2 Year 3 Year 4

Product Pens

Cost per Pen 5 5 5 5

Sales Volume 2,500,000 3,000,000 5,000,000 7,500,000

Fixed Cost 9,000,000 9,000,000 9,000,000 9,000,000

Variable Cost 2 X 2,500,000 =

5,000,000

2 X 3,000,000 =

6,000,000

2 X 5,000,000 =

10,000,000

2 X 7,500,000 =

15,000,000

Operating Profit -1,500,000 0 6,000,000 13,500,000

Profit Analysis - Graph

-9,000,000

-6,000,000

-3,000,000

3,000,000

6,000,000

9,000,000

12,000,000

1,000,000 3,000,000 5,000,000 7,000,000

Break-even Point3,000,000 Pens

Loss Area

Profit Area

Fixed ExpensesRs.9,000,000

Absolute Profitability

• Absolute profitability measures the impact on the organization’s overall profits of adding or dropping a particular segment such as a product or customer – without making any other changes.

Computing Absolute Profitability

• For an Existing Segment

– Compare the revenues that would be lost from dropping that segment to the costs that would be avoided.

• For a New Segment

– Compare the additional revenues from adding that segment to the costs that would be incurred.

Relative Profitability

• Relative profitability is concerned with ranking products, customers, and other business segments to determine which should be emphasized in an environment of scarce resources.

• Managers are interested in ranking segments if a constraint forces them to make trade-offs among segments.

• In the absence of a constraint, all segments that are absolutely profitable should be pursued.

Relative Profitability

• Here is information developed by the management of Matrix, Inc. concerning its two segments:

Segment A Segment B

Incremental Profit Rs.10,000,000 Rs.20,000,000

Amount of constrained resources required 100 hrs 400 hrs

Segment A Segment B

Profitability Index10,000,000

100=1,00,000

20,000,000400

=50,000

Case Study – Product Sales Data

Product Sales Data

Product name xyz

Year 1 estimated unit sales 100

Year 1 unit price 400.00

Unit price compound annual growth rate (years 2 through 5) 5.00%

Year 1 market size (Rupees) 50,000,000

Market size (years 2 through 5) 10.00%

Year 1 variable cost per unit 250.00

Variable cost per unit (years 2 through 5) 5.00%

Year 1 fixed costs 250,000

Fixed cost (years 2 through 5) 3.00%

Target operating income (year 5) 100,000

Target market share (year 5) 2.00%

Scenario for ProfitabilityProduct Sales Data Year 1 Year 2 Year 3 Year 4 Year 5

Unit prices 400.00 420.00 441.00 463.05 486.20

Unit costs 250.00 262.50 275.63 289.41 303.88

Fixed costs 250,000 257,500 265,225 273,182 281,377

Market size 50,000,000 55,000,000 60,500,000 66,550,000 73,205,000

Scenario 1: Based on target operating income

Unit sales 100 209 1,046 1,569 2,092

Sales 40,000 87,853 461,227 726,433 1,017,006

Operating income -235,000 -224,555 -92,265 -769 100,000

Market share 0.08% 0.16% 0.76% 1.09% 1.39%

Scenario 2: Based on target market share

Unit sales 100 301 1,506 2,258 3,011

Sales 40,000 126,474 663,991 1,045,786 1,464,100

Operating income -235,000 -210,072 -16,228 118,988 267,660

Market share 0.08% 0.23% 1.10% 1.57% 2.00%

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