Which products generate the greatest profitability for your company? Which generate the least? Are you losing money on some of your products?
If your company produces, distributes, and/or sells multiple product lines or variations of a product, it is vitally important to understand your profitability for each product line. Without this knowledge, you run the risk of making faulty sales decisions.
Product Mix Decisions
Whether you realize it or not, as a business owner, you routinely face product-mix decisions. The results of these decisions are often integral to your business’s success and profitability. The most successful businesses develop strategic operating plans that seek to maximize and competitively differentiate profitable product lines. This is often in the form of defining an optimal product mix, one that leverages resources in the most efficient and profitable way for the company.
Misunderstanding your costs and not optimizing your product mix can result in competitive disadvantages. But by truly understanding the costs of doing business with every product line, and using this knowledge to strategically define your pricing strategy, you’ll be on the right track to gaining a strong competitive advantage in your industry.
There are a few steps you can take to evaluate your product mix decisions. First of all, you need to understand the exact costs to make, distribute and/or sell each unit. What does it cost your business for each unit you sell? Calculate this by analyzing material costs, labor, overhead and allocated administrative and selling expenses. This is sometimes called a value stream analysis in manufacturing environments.
With this cost-per-unit or cost-per-value stream data, the second step is to compare these costs to your pricing guide. Obviously, price minus cost is your profit. But what are your most profitable items? What causes these items to be profitable? How can you further leverage these products and this information? If items are unprofitable, what are the causes? Will they remain in the business model as strategic “loss leaders,” or will you look into improving efficiencies to reduce costs in these product segments?
Step three involves bringing customer analysis into the decision-making. Are certain customers more profitable than others, based on their purchasing and product mix? How can you encourage unprofitable customers to become more profitable? Is it related to the pricing model used for that customer or is it product mix?
In some cases, you can’t serve a customer’s needs and still make a profit. In this case, you might decide to “fire” the customer. It is a difficult decision to make, but sometimes it must be done to ensure the long-term viability of your business.
Lastly, re-evaluate and update your strategic plan based on the data analysis. It may be necessary to perform a SWOT analysis (SWOT stands for strengths, weaknesses, opportunities and threats). Evaluate your competitive product position in your industry or industries. Combined with your product profitability data, this will help you establish the direction for your business in the coming years.
Armed with this knowledge and a game plan, you can take your company’s operating performance to the next level. This plan will let you focus on competitively differentiating and growing your profitable products and segments, and either improving, outsourcing certain functions, or divesting unprofitable products and segments. Better strategic decisions are within grasp – it’s a matter of knowing exactly where to allocate your efforts and resources.
If you are interested in a detailed product and customer profitability analysis and strategic plan, contact your trusted Rea advisor.
This article was originally published in The Rea Report, Summer 2007.
Note: This content is accurate as of the published date above and is subject to change. Please seek professional advice before acting on any matter contained in this article.