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Product Profitability
DefinitionProduct 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
• Single source of product data that can be utilized across the enterprise to facilitate
a true common reporting platform for product profitability
• Real-time analytic capability of what discounts can be given to customers while
accurately assessing the impact on margins to ensure margin protection
• Provide ‘what-if’ analysis for changes in the cost base allowing for re-forecasting
and preparation for changeable commodity markets
• 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 non-
manufacturing 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 Data Year 1 Year 2 Year 3 Year 4
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
2 X 3,000,000 =
6,000,000
2 X 5,000,000 =
10,000,000
2 X 7,500,000 =
15,000,000
Operating Profit -1,500,000 0 6,000,000 13,500,000
Profit Analysis - Graph
-9,000,000
-6,000,000
-3,000,000
3,000,000
6,000,000
9,000,000
12,000,000
1,000,000 3,000,000 5,000,000 7,000,000
Break-even Point3,000,000 Pens
Loss Area
Profit Area
Fixed ExpensesRs.9,000,000
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 resources.
• Managers are interested in 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 Segment B
Incremental Profit Rs.10,000,000 Rs.20,000,000
Amount of constrained resources required 100 hrs 400 hrs
Segment A Segment B
Profitability Index10,000,000
100=1,00,000
20,000,000400
=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 through 5) 5.00%
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 250,000
Fixed cost (years 2 through 5) 3.00%
Target operating income (year 5) 100,000
Target market share (year 5) 2.00%
Scenario for ProfitabilityProduct 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
Fixed costs 250,000 257,500 265,225 273,182 281,377
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 100 209 1,046 1,569 2,092
Sales 40,000 87,853 461,227 726,433 1,017,006
Operating income -235,000 -224,555 -92,265 -769 100,000
Market share 0.08% 0.16% 0.76% 1.09% 1.39%
Scenario 2: Based on target market share
Unit sales 100 301 1,506 2,258 3,011
Sales 40,000 126,474 663,991 1,045,786 1,464,100
Operating income -235,000 -210,072 -16,228 118,988 267,660
Market share 0.08% 0.23% 1.10% 1.57% 2.00%
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