Want to earn $1 million per year? One way to do it is to put about $200 million into your checking account. Than you can earn the 0.5% annual interest it will pay. What? You don't like that? Picky, aren't you?
Earning only 0.5% on invested money is not the sort of thing that would make me happy. (Having $200 million to invest would make me happy, but that's another story.) Being able to identify the profit dollars generated by each of the product lines in your Company's business, or by each of the products in your product line, is a very satisfying, useful thing. (See accompanying article "Product Line Profitability Modeling.") Knowing those profitabilities and the factors that drive them enables you to plan and take actions to grow profits.
Your plans to grow profits will probably have both defense and offensive implications. In the process of your analysis you'll probably become aware of factors that tend to erode profits. You would be aware that something was wrong and start trying to determine what to do about it. In other words, you would try to eliminate negative influences on profitability. That's defensive. It is also in keeping with human nature. We all seem to be inherently better at recognizing threats than we are at perceiving opportunities. Offensive plans may include ways to build sales volume or markedly lower manufacturing cost, or perhaps even develop a new product. These positively oriented, profit-enhancing plans will require investment. Your Company's capacity to invest is finite. In times of depressed equities markets, that capacity to invest may be severely restricted, so it would help to know where an investment might produce the greatest returns. Your product line profitability analysis gives you a good jumping-off point so that you can learn what you need to know.
It is common for Companies to develop income statements for organizational units that are not legal entities. It is not common that they also develop balance sheets for those same business units. But, you can do your own estimates for the assets used by each of the product lines in your analysis. I've learned that having some facts is better than having no facts at all. Relative asset utilization among the product lines is something that you should be able to determine.
Relative Asset Utilization
You'll want to identify assets that are dedicated to each of the product lines. Further, you'll want to do that without resorting to any asset allocation formula.
Consider inventory. Inventory is usually classified as raw material, work in process, and finished goods. Your finished goods inventory will be identifiable as specific models, and therefore part of a specific product line. Don't forget demonstration equipment including any which might be on consignment or loan to customers. Some of the in-process inventory should be identifiable too. You can ask your Materials Manager if he has inventory breakdowns by product or model. Whatever you can learn belongs to each product line can be recorded as part of the asset base dedicated to that line.
Consider accounts receivable. If your accounting department can segregate accounts receivable by product line or product, ask them to do it for you. You may be pleasantly surprised at how much you can get. If they don't, or won't do such reports, find the accounts receivable aging statements, and look for the accounts which are the longest overdue. You can bet that your collections department has a very detailed list of such accounts. That list will probably tell you which products those slow-paying customers purchased. Any accounts receivable amounts you can specifically attribute to each product line should be added to the asset base total invested in that line. Additionally, the information you gain about slow payments associated with a particular product line may give you clues for improvement of that line's profitability.
Non-current assets include property, plant and equipment. You can depend on the accounting department to have detailed lists of your Company's fixed assets and their current, depreciated values. If you know that one or more of the product lines uses a dedicated building, a custom piece of production equipment or the like, add the book value of that dedicated asset to the asset base total invested in the product line.
Do any of your customers prepay? Are down payments required for products? Are maintenance agreements paid for in advance? If so, your company probably records those prepayments as customer liabilities. The accounting department should be able to provide you with a detailed list. Any customer cash you have in hand reduces the net investment in the product line. So, if you find prepayments, subtract them from the asset base investment for each product line. You have now been able to identify dedicated net asset investments in the product lines. They won't total to your entity's balance sheet, but they do give you relative asset utilization by each of the product lines.
The Cost of Money
The relative asset utilization totals you're just created represent money invested in each of those product lines. In an income statement, you get to net income by subtracting interest and taxes from operating income. What you've done in a product line profitability analysis is get to the operating income level for each line. The equivalent of interest is the cost of the money invested in each product line.
If you asked you Company's senior executives for the Company's cost of capital, you would get more strange looks than answers. Cost of capital is a subject much debated even within the finance community. It does not mean just the interest rate that the Company may be paying on its bank lines of credit. I suggest that, for your analysis, you use a figure that is characteristic of credit card debt. Pick a number like 15% or 18%, or perhaps as high as 20% and attribute that as the cost of the investment in the relative asset base of each product line. Subtract that cost of invested capital from the "profit" you previously calculated for each product line and you'll have a pretax income figure for each line. The heavy cost of invested capital you use may well point out which product lines really represent the better returns on investment. That makes your product line profitability analysis even more valuable!