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Product/Product Line Profitability Modeling, Part1
by Joe Verderber
Does your Company have only one single product? I doubt it. Most firms not only have multiple products, but also multiple product lines. This is a natural outcome of attempting to capitalize on the firm's strategic strengths, whether they are in proprietary technologies or in well-cultivated customer relationships. Your business is an amalgam of many products, each in its own phase of the product life cycle. In the light of this rich complexity in your business, it is very easy for the real profit contribution from an individual product line or product to be unknown, or even worse, misinterpreted.
Your Company's accounting system is designed for timely capture and reporting of all revenue and expense transactions, and for accurate computation of the costs of the goods and services you deliver. It is subject to internal and external audits to insure both its soundness and its proper use. Consequently you can be reasonably confident that the Company's overall financial status and health is accurately reported. Unfortunately, the same is not true for the status and health of any given product or product line. The accounting concept of Materiality virtually mandates that even items that may be extremely significant for a given product or product line will be ignored as immaterial to your Company as a whole, and only reported lumped into some other aggregate.
If you're interested in product line profitability you can implement a solution yourself. You can create your own accounting system solely for that purpose. (The same techniques can be used within a given product line to determine the profitability of each product.) As a basis you will use some of the financial reports and data gathered and generated so painstakingly by your accounting department. Your job will be easier than theirs, because you'll be looking for a "snapshot" or two of profitability rather than having to deliver a regular and repeating set of reports each accounting period. You will create your profitability analysis by concentrating on the ACTIVITIES specifically associated with each product line, and the PEOPLE who carry out those activities.
Fixing "Fixed" Costs
It is common practice to consider some departments or functions within an organization as being "fixed costs". By definition, they are assumed to exist regardless of the level of business of the Company. They are considered part of overhead and distributed in some way over all product lines. Usually they are prorated on the basis of revenue. A wise man one told me that a department should be considered part of fixed cost only if there is just one person in it. If more than one, it is because of the volume of work. Volume of work is attributable to a specific product or product line if one takes the time to do it. So one big difference between accounting's overall financial statements for the Company and your product line profitability analysis will be that you're able to identify more costs and expenses as "variable" rather than "fixed".
The secret to learning the real variability of costs and expenses lies in discovering who are the people who spend their time working on each particular product line and its business transactions. To do that you will have to understand how your business really works. Some may call that learning the "cost structure" of the products and the "expense structure" of the organization. A product line manager who masters and internalizes the cost and expense structures impacting his product lines will be in a great position to make improvements. For example there are many reasons why two products could have the identical unit price and standard cost, the same annual revenue and yet markedly different real profitabilities. One product could be sold and shipped in single units, while the other is shipped and billed by the pair or dozen or case. One could be 100% defect free and the other could suffer from some early field failures that require repair or replacement. Would your current financial reports allow you to see a difference in profitability between the two products? The people who do the invoicing or the shipping, or handle the complaints or perform the repairs could tell you a lot about each of the product lines if you ask them. If you do, you're on your way to being able to develop a good product line profitability analysis.
To build a good product line profitability analysis, you'll base it on people. You'll learn about their activities, and how particular product lines drive those activities. That principle will carry all through your organization from R&D labs to the factory and into the accounting department. Much of the work of an accounting department, for example, has to do with executing, tracking and collecting on invoices. Invoices come from specific product shipments and transactions. So, at least some of accounting is not just "fixed" cost to be allocated across product lines by revenue.
How will you find out about the product-line specific activities and the time people spend on them? You will talk to the supervisors or managers of all the functional groups in your organization. If you have a good feel for the responsibilities and activities of each of the functions in your organization, you're well on your way. If not, then you'll have to find a person or persons to serve as your organizational guide and lead you through the activity flows. If your organization is ISO 9000 certified, the process documents that are the heart of the certification can be your guide to the way the Company is supposed to work. Find them and read them, and discuss them with the people who actually wrote them. One or more of those people would make a great guide for you if you need one.
Credibility
When you complete your product line profitability analysis, you will be sharing it with other people. Perhaps you'll want them to help you analyze the results and do action planning. Perhaps you'll be asking for authorization to do something based on your findings. If you need not ask for authorization before you decide to take action, you'll be depending on others for implementation. You would no doubt want to share with them the basis for the action. Frankly, you want to be able to convince even yourself that your analysis is credible. How can that be done? One method is to tie the analysis to financial statements published by the accounting department.
Does your business entity have its own income statement? If so, you're in great shape. Many companies publish at least income statements for various parts of their organization. For example, the Company may be a US public company, which of course means that it regularly publishes an audited set of financial statements. Those statements will consolidate all the Company's organizations and activities including those of any subsidiary in the USA or abroad. Each of those subsidiaries, of course, will have their own legally mandated set of financial reports and statements. As an aid to upper management the company may well produce income statements for its major organizational units even if they aren't legal entities.
To use the reference information, you must show how the results shown in, say, the income statement spread across all the product lines. This is a very important point. You won't have credibility if you just show the total and one of the product lines which go into it. You must show how all the revenue, and all the costs and all the expenses divide among the product lines. Otherwise neither you nor anyone else can be reasonably certain that activities and their staffing and costs have been properly accounted for. So, whether you like it or not, your attempt to come up with a product line profitability analysis will mean that you develop an analysis covering all the Company's product lines. (That is, at least all of them involved in the income statement you get from accounting.)
The Payoff
Creation of a product line profitability analysis is a process that you will probably come to find you value much more that the numbers on the resultant document. You'll find that the things that erode profitability will probably become very obvious to you. The experience will enable you to better avoid future problems as well as to find solutions to current ones. You may also find that creation of the product line profitability analysis gives you more of a broad, "general manager's" feel for the business. Sharing those insights can make you a more effective "coach" and mentor for your co-workers.
