Product Profitability

Product Profitability

Definition Product 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

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Single source of product data that can be utilized across the enterprise to facilitate a true common reporting platform for product profitability

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Real-time analytic capability of what discounts can be given to customers while accurately assessing the impact on margins to ensure margin protection

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Provide ‘what-if’ analysis for changes in the cost base allowing for re-forecasting and preparation for changeable commodity markets

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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 nonmanufacturing 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

Year 1

Year 2

Year 3

Year 4

Data 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

Operating Profit

-1,500,000

2 X 3,000,000 2 X 5,000,000 = 2 X 7,500,000 = 6,000,000

10,000,000

= 15,000,000

0

6,000,000

13,500,000

Profit Analysis - Graph 12,000,0 00 9,000,00 0 6,000,00 0 3,000,00 0 3,000,00 0 6,000,00 0 9,000,00 0

Profit Area 1,000,000

3,000,000

5,000,000

7,000,000

Loss Area

Fixed Expenses Rs.9,000,000

Break-even Point 3,000,000 Pens

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 • Managers are interested in resources. 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

Incremental Profit Amount of constrained resources required

Rs.10,000,000 Rs.20,000,00 0 100 hrs Segment A

Profitability Index

Segment B

10,000,000 100 =1,00,000

400 hrs Segment B 20,000,000 400 =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

5.00%

through 5) 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 Fixed cost (years 2 through 5) Target operating income (year 5) Target market share (year 5)

250,000 3.00% 100,000 2.00%

Scenario for Profitability Product 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

250,000

257,500

265,225

273,182

281,377

Fixed costs 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 Sales Operating income Market share

100

209

1,046

1,569

2,092

40,000

87,853

461,227

726,433

1,017,006

-235,000

-224,555

-92,265

-769

100,000

0.08%

0.16%

0.76%

1.09%

1.39%

Scenario 2: Based on target market share Unit sales Sales Operating income Market share

100

301

1,506

2,258

3,011

40,000

126,474

663,991

1,045,786

1,464,100

-235,000

-210,072

-16,228

118,988

267,660

0.08%

0.23%

1.10%

1.57%

2.00%

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