Understanding product-level profitability is crucial for every small business. This analysis will help you make better-informed decisions about product pricing, selection, and promotional strategies.
The challenge is that it can be very tedious and time-consuming. But it doesn’t have to be. With the right tools and a practical approach, you can quickly start measuring and improving your profitability.
This guide will provide you with an efficient and effective method for understanding and improving product-level profitability.
Embarking on profitability analysis can seem overwhelming. Yet, it’s important to remember that actionable data is far better than perfect data. So, it’s not as difficult as it may seem at first.
Precision is critical in income statements and other regulatory-driven accounting functions. However, as a decision-support tool, product-level profitability analysis just needs to be “directionally correct.” By pointing you in the right direction, you can quickly implement changes to help improve profitability.
You simply start by calculating the profitability of your most important product. And then your second-most important product. And so on for the rest of your top products. At this point, you’ll be able to estimate the rest of the products without a significant impact on the quality of the analysis. We’ll delve deeper into this approach later.
Once you start seeing the profitability trends for your top products, you will be motivated to dive deeper because of the great insights you’ll find. You’ll also start to learn where more (or less) accuracy is needed in this analysis.
Clear and consistent definitions of “sales” and “cost” are vital to ensuring an accurate profitability analysis, as well as well-informed decisions based on this analysis.
Profitability is simply sales minus cost. However, these terms can have varying definitions based on industry and context. Fortunately, you can define these terms to fit your specific needs – as long as you are consistent.
For those familiar with accounting terms, this approach calculates gross profit by subtracting the cost of goods sold from revenue. But again, this is not an accounting exercise, so define these terms so they make sense for your business. Just be consistent.
Using standardized definitions makes it easier to find general industry benchmarks for comparison. For example, the RMA Statement Studies (available for free at some local libraries) show that the gross profit margin for bakeries is 62.7%.
You can also use consulting experts from your local SBDC or SCORE chapter to help set realistic benchmarks for your business.
Ultimately, your most important and useful benchmark will probably be your historical performance. Comparing current profitability to past results can provide a tangible measure of progress.
Calculating the profitability of every product is not practical or necessary. Instead, start by estimating your gross profit margin for the entire business as well as for each category. This provides a reasonable starting point for all of your products. Then, focus your time on doing a detailed cost analysis for your most important products to improve the accuracy of this analysis.
If you’re using the Manage My Business app, simply enter these values into the Profitability Analysis section. The profitability metrics and graphs will update automatically.
It’s easy to determine the cost of simple products like a t-shirt or bottle of water, but what about more complex products like a baked-from-scratch cupcake? Let’s walk through this example to highlight where shortcuts can simplify this process.
One additional layer of complexity exists for products with variable prices, such as a latte. The cost will vary based on perhaps thousands of combinations of factors such as cup size, extra shots, flavors, or specialty milks. There are a couple of solutions for this issue:
Remember, the goal is to get a reasonably good estimate, which you can refine over time.
One final recommendation is to take notes on how you calculated the cost for each product so you can replicate this process in the future, as you will need to repeat this process from time to time. The first time is the hardest, but you can make subsequent estimates much easier and more consistent by documenting your assumptions.
Through the simple act of calculating costs, valuable insights often emerge. In the cupcake example above, you might find that one ingredient (like vanilla) has a significant impact on the cost. This could lead to ideas to tweak the recipe, seek cost-effective alternatives, or even find a new supplier – ideally without compromising the quality of your product. Moreover, examining labor costs might uncover opportunities for efficiency, like simplifying production steps or investing in more capable machinery to improve automation or scalability.
Visualization tools transform data into actionable insights. A Gross Profit Margin Heatmap, for example, can highlight which times of day or days of the week yield higher profits. A restaurant may find their breakfast orders are wildly profitable, but they lose money during the lunch hour.
In the following example, you can see that this business is more profitable in the afternoons (shown by the darker green color):
Once you’ve updated your costs over a period of months or years, trend graphs become really useful. For example, if your costs are rising over a few months, you will see your profit margin shrink over that same period. This graph becomes a good indicator of when to consider raising the price of that product. In the following example, you can see the profit margin was falling because of rising costs until a price increase returned it to a healthier level.
These are just a few examples. The deeper you get into product-level profitability analysis, the more you’ll find that almost every decision is impacted in some way. The result can be a more profitable business.
Repeat the process of updating your product costs regularly – perhaps every 3-6 months. Costs are changing rapidly right now, so a year-old estimate probably isn’t relevant today (except for comparisons over time). Remain focused on your key products and make updates whenever a significant change occurs to the underlying costs.
Boosting profits begins with the often challenging task of analyzing product-level profitability. However, by embracing this practical, streamlined approach, you can start quickly making decisions that incrementally steer your business towards greater financial success.
To learn more about using Manage My Business with a Clover POS, visit the Clover App Market.
This information is provided for informational purposes only and should not be construed as legal, financial, or tax advice. Readers should contact their attorneys, financial advisors, or tax professionals to obtain advice with respect to any particular matter.
Sign up and learn more about Clover.