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!
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:
price for each product.
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.
Cost of outsourced work.
Cost of other direct costs related to preparing the product for delivery
or sale (freight, packaging, supplies, etc.)
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
To calculate your total activity-based cost you
profit for each product
Sales costs. This is the amount
of time you and your sales staff spend to sell the product.
Advertising costs. This is the
cost of any advertising you run on this particular product.
Delivery and freight costs.
Collection costs. This is
particularly important if you are in the medical field and bill Medicare,
Medicaid, or private insurance.
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!