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.
- Less: Sales costs.
- 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!