The Ultimate Guide to
An organization’s profitability depends on the profits you generate from each of your products. So, it’s important for you to calculate the impact your individual products contribute to your bottom line.
Analyzing the profit-and-loss responsibility of your products individually can uncover opportunities. When you know which products are profit takers—the underperformers—you can tackle the problems leading to their poor performance or decide to eliminate those products. And when you know which products are profit-makers—the ones that contribute the most to your bottom line—you can look for ways to further increase their sales.
However, breaking down your business expenses and allocating them among your various products isn’t easy. In this guide, you’ll learn which three product groups influence your profit, how to conduct a product profitability analysis for your company and what challenges to watch out for as you complete this analysis.
Product profitability defined
Profit, of course, is the amount of money remaining after you subtract expenses, debt and any other costs. Product profitability refers to the amount of profit you can attribute to a specific product after you account for the expenses associated with that product.
For example, suppose your company sells small kitchen appliances. At the end of a quarter, your profit margin is 15%. But your different products—say, toasters, coffee makers and pressure cookers—contribute different amounts to your overall profit margin. By looking at product profitability, you can make decisions that can boost profits. Maybe you’ll promote sales of your most profitable products with targeted marketing strategies or retire that underperforming mixer.
Analyzing the profit-and-loss responsibility of your products individually can uncover opportunities.
Why is product profitability important?
When you calculate product profitability, you monitor and analyze key performance indicators, so you know how well your product is performing in your market. You know how much profit you can attribute to each individual product. With that information, you can make crucial decisions about how to operate your business and how to increase your revenues. Product profitability can inform your decisions about:
- How your product impacts company operations
- Which products deserve more investments of time and/or money
- Which products you promote to which customers
- How to advertise your products
- Whether to increase pricing on products
- Which products you might want to discontinue
- Whether you should bundle or cross-sell products
3 product groups that influence profit
When you’re trying to maximize profitability, your company’s consolidated financial statement gives you a lot of important and valuable information. Unfortunately, it doesn’t give you much insight into the ways profit can vary within your business. The revenue and gross margin statistics that show up in your consolidated financial statement don’t provide you with details about transactions, vendor and product families, customers, sales territories, brands, customer groups and other factors that can influence changes in your net profitability.
There are three distinct groups of customers and products that result in your definitive net income. They are:
- Profit makers: your products and customers that increase your peak internal profitability
- Profit neutrals: your products and customers that either maintain or match your peak internal profitability
- Profit takers: your products and customers that reduce your peak internal profitability
The dynamics among these three groups—and your company’s efforts to understand and influence these dynamics—determine the actual net profit of your business. They drive your business’s enterprise value and your ability to target and manage profitable product growth.
A deeper analysis is crucial for understanding the true profitability of your products. That’s because two customers with the same gross margin can consume your organizational resources at different rates. When your company grows its profit makers, improves its profit neutrals and remedies its profit takers, it can direct its resources toward optimal, profitable growth.
Regrettably, most product managers don’t know where their products or customers fall among the three profit categories. So, they fail to identify and mitigate profit takers, which reduces net income and enterprise value. Additionally, they often don’t focus enough work, sales and support on the segments that drive profitable growth and market leadership.
Interestingly, many executives believe that their largest customers and product categories are their most profitable. But this assumption is often false. When you appropriately attribute the true cost to serve (CTS), you’ll likely find your sizeable customers and categories across all three profitability groups.
When you’re trying to maximize profitability, your company’s consolidated financial statement gives you a lot of important and valuable information.
How to conduct a product profitability
To determine how profitable a product is, you need to track and analyze the costs associated with the product. That might sound straightforward, but there may be a lot of costs to include, and determining how much of a cost to attribute to a specific product can be challenging.
Take the small kitchen appliances business mentioned earlier, for example. There’s the cost of the components that make up the appliances, labor for the workers who build them, electricity to power the plant where they are made, shipping to the customer or store, etc.
Then, there are additional costs that you need to allocate among your products. That includes your salary and the salaries of executives and office staff, marketing expenses, website hosting, rent or lease payments, loan payments, utilities, cleaning services, etc.
You also may need to account for markdowns and discounts, shoplifting and damaged products.
To conduct a product profitability analysis, take the revenue generated from the sales of your product and subtract out these costs. That will show you the amount of revenue you’ve generated from that product.
Keep in mind that product profitability can change. That’s because these costs aren’t always stable. After you have tracked and allocated them, they can fluctuate, driving your product profitability higher or lower.
Challenges in identifying product profitability
Today’s macro income statements do not calculate profitability at the granular level you need to make decisions about your products. While they include revenue and gross margin calculations, they are inadequate for identifying profitability for individual products or customers.
You need a different tool—true profitability analysis (TPA). By implementing this critical analysis, product management leaders can help executives, managers and sales teams identify their profitable, neutral and unprofitable products and clients. TPA also gives you insights into the drivers that produce these outcomes.
To analyze what’s driving your net income, it’s important to start by calculating—at the line-item level—the volumes, prices and cost of goods sold. This calculation leads you to your gross margin and gross profit.
Then, to arrive at your net income, you must assign the operational costs of your invoice line items to the products and customers served. Along with assigning operational costs, you must also identify whether these costs are fixed, semi-fixed or variable. That’s important because they will rise and fall differently when your sales volume changes.
Over short and medium terms, fixed costs do not change proportionally with large changes in volume. Semi-fixed costs vary when you trigger specific step-level volume changes. And variable costs change quickly in proportion to sales volume. When you understand operating costs at this level, your executives and staff can determine whether remediating underperforming market segments and restructuring operations can help achieve greater efficiencies. They can also decide whether (and how) to serve, expand, shed or restructure market segments, customers and product offerings.
The 80/20 Rule and the Whale Curve
You’re probably familiar with Pareto’s Principle or the 80/20 rule. It outlines how the top 20% of data points contribute 80% of value outcomes, and the bottom 80% of data points contribute just 20% of value outcomes. This principle is a popular way to understand the opportunities you have to simplify, prioritize and exploit your competitive advantages.
However, when it comes to customer and product profitability, the Pareto Principle doesn’t account for the underlying economic levers in business. Your business—like all businesses—has its characteristics. Within your company, segments and territories will have different properties and ratios.
Once you’ve assigned your operating costs to your individual customers and products, you can illustrate the results in a graphic depicting, in descending order, the net profit of all of your customers and products. This type of graph is often called the whale curve because it resembles a whale breaching through the surface of the ocean. It shows you your profit makers, profit neutrals and profit takers; who makes up each group; and the effect they have in determining peak profit versus net profit. (See Figure 1.)
In a whale curve, you rank your customers or products by profitability, from highest to lowest. On the X-axis, you plot your customers or products. On the Y-axis, you have your accumulated profit.
For most businesses, the range of peak internal profit to net profit called the whale ratio, ranges from 1.5 to 3. Within a smaller sample, for example, a sales territory, the ranges can be significantly higher.
Generally, in whale curve economics:
- The top 20% of clients tend to be clear profit makers, contributing between 150% and 300% of your net profits
- The middle 60% tend to be profit neutrals
- The bottom 20% tend to be profit takers, destroying from 50% to 67% of your peak internal profit
You can remember this critical insight by calling it the 20/300 rule (focusing on the profit makers) or the 20/67 rule (focusing on the profit takers). More important than what you call this insight, though, is to remember it and act on it.
Once you graph the whale curve, you can share it with your executives and sales teams. Starting on the right side of the curve—the profit takers—your team, can make several choices that can help tamp down the whale’s tale or move the profit takers toward profitability:
- Raise the product price
- Ask for cost support from the vendor
- Sell more products and services (since the increased spend amortizes the margin across the total sale)
- Lower the cost of sale by using inside sales reps or assigning this account to an inside sales team
- Lower the cost of sale by having the customer order electronically
- Work with production to lower the cost to manufacture
- Work with sales to lower the cost to serve (CTS)
Let’s look at some hypothetical numbers. If your business has $1 million of net profit, it is likely that your peak internal profit—before your profit takers reduced net profit—was $1.5 million to $3 million. If your company had identified and remediated or discharged its profit takers, the potential net profit could have been 50% to 200% higher. Most notably, your company would prosper without adding customers or suppliers, raising quotas or opening new operations. You would be managing for profitable growth and setting your business up to become a strategic market maker instead of an indiscriminate order taker.
You should also focus on the profit makers so you can identify them and create plans to grow and replicate them. For example, you might:
- Offer a strong customer a discount if the increased sales will boost profit
- Target a customer that’s growing quickly, since their growth can fuel increased sales
- Sell a new product to a profitable customer
The whale ratio, how it’s distributed, and how it varies are a critical set of metrics you can use to identify where and how to remediate underlying profit drivers. The whale ratio can also guide you as you revamp cost structures and growth targets, and it gives you a way to align your organizational resources in ways that maximize your profitable growth.
When product profitability is the wrong metric
Ultimately, product profitability is the goal. But profitability isn’t always the right metric to measure. Depending on where your product is in its lifecycle, you may want to look at other ways to measure its success. But how do you know when to focus on profitability and when to focus on other metrics?
When you’re early in your product’s lifecycle, you may not want to focus on profitability or even revenue just yet. It may be best to focus on gathering and analyzing information. For example:
- Is this the right product?
- Is this the right market?
- Is it solving a problem?
- Have you identified the right personas?
When you’re still evaluating product market fit, focusing on profitability isn’t your top priority. At this stage, you’re investing a lot of money into development and, possibly, marketing, so you’re probably not making a profit.
Before you focus on profitability, you want to build up a small group of customers and find out what they really think about your product. You may even want to offer your product for free in exchange for their feedback. If you took your product away, would they be devastated? That’s a good sign you’re onto something. What features can’t they live without? Those might be your differentiators.
You also want to analyze what your customers are doing with your product:
- How are they using it?
- What steps do they go through?
- What features do they use and what don’t they use?
- How much time do they spend in different areas?
- What’s their retention rate?
In addition, you should focus on “stickiness” before you focus on profitability. In the long run, stickiness is about retention. You want to make sure your product isn’t just a fad—it needs to have staying power for the long run. That doesn’t mean every customer should be using your product every day. Weekly, monthly or even yearly usage (for example, if you sell tax software) might be the ideal timeframe for your customers.
In the early stages, a focus on product profitability could push you to grow too fast. If your growth is fast, a lot of your existing and potential customers could learn about flaws and view your product negatively while you’re working out the issues that inevitably arise with a new product. But if you grow more slowly, as problems crop up you can solve them before they affect a lot of products or customers.
For a deeper dive into when product profitability is the wrong metric for success, listen to our podcast.
Learn more about product profitability
Understanding how to measure product profitability—and how to use that information to increase your company’s overall profitability—is crucial to business growth and long-term success. Register for Pragmatic Institute’s Focus class today to learn more about how to evaluate product profitability.