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Product Profitability

Definition
Product 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 Year 1 Year 2 Year 3 Year 4


Data
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 2 X 3,000,000 2 X 5,000,000 = 2 X 7,500,000
= 5,000,000 = 6,000,000 10,000,000 = 15,000,000

Operating Profit -1,500,000 0 6,000,000 13,500,000


Profit Analysis - Graph

12,000,0
00
9,000,00
0
6,000,00
0 Profit
3,000,00
Area
0
1,000,000 5,000,000 7,000,000
3,000,000
- Loss
3,000,00 Area
-
0 Break-even
6,000,00
- Point
0
9,000,00 3,000,000
0 Fixed Pens
Expenses
Rs.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.20,000,00
0
Amount of constrained resources required 100 hrs 400 hrs

Segment A Segment B

Profitability Index 10,000,000 20,000,000


100 400
=1,00,000 =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 5.00%
through 5)
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 Profitability
Product 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%
Thank You