Not knowing your true costs & opportunity costs can seriously lower your business profits. Learn why you must know your costs & how to calculate them
Make Sure All Your Products Are Cash Cows
All business owners know that not all products are created equally. There are some products they make a ton of money on and others where they barely break even. But it is amazing how many business owners don’t really know what products they make the most money on. They focus on those products that they make very little profit on and ignore those that are real cash cows. Even worse, I have seen business owners who have unintentionally put a product on sale below their costs, and then spend advertising dollars to sell even more items at a loss!
Why? The business owner is either just trusting their gut and their back-of-the-cocktail-napkin calculation from years ago, or they are not calculating their product costs.
The Starting Point: Calculating Gross Profit by Product
First, calculate the gross profit for each product using a spreadsheet as follows:
- Sales price for each product.
- Less: Purchase price of product.
- Less: Cost of direct labor for each product. This is best calculated using a standard rate times the standard number of hours to produce the product or service.
- Less: Cost of outsourced work.
- Less: Cost of other direct costs related to preparing the product for delivery or sale (freight, packaging, supplies, etc.)
- Equals: Gross profit for each product
Advanced Product Cost Management: Activity-Based Costing
If you have already calculated your gross profit per product, congratulations! This puts you in the top 10 percent of business owners who manage their profits to this detail. Now the bad news: You have just started. I have seen business owners make costly mistakes because they did not know the total cost incurred throughout the sale, from taking the order to delivering the product and collecting the invoice.
I had the owner of a commercial glass installation company who called me in because his sales had increased by 50 percent but his profits had dropped by 25 percent. When I did activity-based costing on his major products, I found that he had put a new type of glass on sale that was taking his staff almost three times as long to install. When we added this installation time to the product cost, we found out he was losing about 10 percent on each sale with his current pricing. But it got worse! He was having a 10 percent off sale on that item for the month. This meant that he was now losing 20 percent on an item that, because of the sale, was selling out quickly.
To calculate your total activity-based cost you take:
- Gross profit for each product
- Less: Sales costs. This is the amount of time you and your sales staff spend to sell the product.
- Less: Advertising costs. This is the cost of any advertising you run on this particular product.
- Less: Delivery and freight costs.
- Less: Collection costs. This is particularly important if you are in the medical field and bill Medicare, Medicaid, or private insurance.
- Equals: True Product Profit
Knowing your true product profit is the key to making good profit management decisions. You will now be able to focus on your most profitable products while eliminating or reducing those that add little or nothing to your bottom line. Let your competitors focus on the losers. You will now be focusing on your cash cow products!