Do you make more money selling cookies or cupcakes? Who's more important to your business: the big customer who ties up half your workforce, or the dozen smaller customers who occupy the other half?
Knowing which of your products or services generates the biggest profit margins is critical to building a sustainable business. It helps you determine where you should focus your resources for future growth, and where you should be trying hardest to cut costs or raise prices. Yet surprising numbers of small-business owners overlook this fundamental exercise.
"Too many business owners think in terms of sales and revenues, and not the bottom line," says Joellen Sommer, a certified public accountant whose New York City-based consulting firm, Your Own CFO, provides clients with on-call, part-time or interim chief financial officers. "They really don't know what the cost is to produce a certain product, or at least not the all-in cost. If they provide a service, very few track the true cost of their employees who deliver it."
Sommer recalls working with a firm in the advertising industry that was shocked to discover that its largest client was actually costing the company money. When it came time to rebid the business, her customer let the client go rather than try to hold its prices, then redirected its energy to finding new clients.
Engineer and entrepreneur Robert Sherwood had a similar epiphany several years ago. After a long and successful career in Silicon Valley in which he grew one of his startups to $100 million in revenues in just three years, Sherwood returned to his home state of Kansas and launched SmartText Corp., a small company that sells legal forms and business documents via the internet.
For years, Sherwood assumed that his highest-priced products generated his biggest profit margins. After all, once he'd developed a large and complex document, it cost nothing more to deliver over the internet than one of his simpler forms. What he failed to consider were post-sale costs. It turned out that customers spending $150 on a document were a lot more demanding than customers shelling out $10. When they had trouble figuring out how to download a purchase or save it to a hard drive, they were much more likely to call his company for help.
Sherwood tried beefing up the "frequently asked questions" page on his website and offering alternative delivery methods, such as file transfer protocol, to ease the burden, but to no avail. Finally, he began to position his lower-cost but higher-margin products more prominently on his website. That led to lower revenues as his average selling price fell, but higher profits as customer service calls went down. On sales of about $1 million annually, profits rose by nearly $150,000.
Crunching the numbers
The simplest way to measure the profitability of a product or service is by its gross margin: the sales price less the direct material and labor costs to produce it, divided by the sales price. If, for example, your $25 widgets cost $20 to produce, your profit margin is 20 percent.
For many companies, however, that is only a starting point. The gross margin calculation does not include overhead expenses like rent or equipment costs, or even selling expenses. The more of those costs you factor in--especially where they vary significantly from product to product or service to service--the more accurate a picture you'll get of your true profit margin.
Using the data
Once you've calculated profit margins for your various products or services, you'll need to decide what to do with the information. In simple terms, you might do one of three things with low-margin elements of your business: cut production costs, raise prices, or, if neither is possible, discontinue offering the product or service. The real world is more complex. Fast-food chains might enjoy their biggest profit margins on french fries and soft drinks, for example, but they're not about to stop selling cheeseburgers. Most businesses need to offer a well-rounded menu of products and services to attract and retain customers. But there is still much you can do.
Consider the experience of FHI Heat Inc., a Solon, Ohio-based producer of flatirons, blow-dryers and other hair-care products. After joining the company in 2008, CFO Michael Paull began a rigorous analysis of its profit margins by product, product line, distribution channel and customer. Using the results of that analysis, the company has seized opportunities to pair low- and high-margin products together in offers that create higher-blended profit margins while also boosting sales (think of fast-food value meals). It has also negotiated price breaks from vendors where possible, and in some cases raised its selling prices--even at the cost of losing a few low-margin customers. Over the past two years, Paull says, the effort has helped the company double its profit margins.
Are you ready to take a closer look at which goods and services generate your best profits? Here are four tips:
- Verify the integrity of your data. Unless you have a good handle on your true cost inputs, you can't hope to calculate profit margins accurately.
- Share your findings with other decision makers in your organization who can impact what it costs to produce your goods or services and what you charge.
- Consider the indirect consequences of any changes you make. Just because one product has lower profit margins than another doesn't necessarily mean it should be dumped. Different products and price points appeal to different customers. And in sufficient volume, low-margin products can generate more profits than high-margin products that are moving slowly.
- Make margin analysis an ongoing discipline. Your product offerings, costs and pricing power are constantly shifting. Depending upon the nature of your business, consider monitoring margins on a quarterly or monthly basis.
A former reporter for The Wall Street Journal and Dow Jones and contributor to Barron's, Randy Myers is a contributing editor for CFO and Corporate Board Member magazines.