In my journey, as Strategic Advisor for a growing businesses, people often ask me, how do I know if my product is profitable? To find out, we must identify direct and indirect cost.
What is factored into product profitability?
As most of us know, the cost of sales can be classified into direct and indirect costs. It is relatively easier to measure direct cost, which consists of the cost of labour and material. But indirect cost is something that is not directly attributable to a specific product, like sales & marketing, financing, support functions and common infrastructure (factory, warehouse, maintenance of the plant & machinery etc). These costs are very significant, sometimes more than the direct costs.Profit is what remains after the direct/indirect cost of sales.
Complexity related to indirect costs :
Some products may require more effort to sell, but carry a high absolute margin; while others may have small absolute margin but require less effort to move. Other products may have a long selling cycle, but low inventory maintenance cost; yet, others may have a short selling cycle, but high inventory maintenance and tight supply chain management need. It is imperative that we measure the indirect cost of sales for all products correctly, being aware of these different dynamics, to derive the profitability of each product.
Considering all this, we are left with a complex model of delivery. In such a model, how can profitability be correctly measured? Too often, only the direct cost is considered relevant and correctly measured, while the indirect cost is neglected and allocated to products on the basis of total sale value. This approach skews the picture of profitability of the products in the portfolio, with the result that the “average” or “below average” products appear to make a bottom-line profit or much better profit, whereas, in reality, these “not-so-fast moving” products are simply a drag on the business, such profitability is an optical illusion resulting from subsidization of profits of best products.
In a nutshell, measuring profits based on gross sales may give a very misleading picture, which may result in making decision related to product portfolio that is detrimental to the business. And so, it’s imperative that the business shun arbitrary allocation of indirect costs and invest in creating a system that identifies indirect costs against products. This will lead to arriving at the correct profitability of each product segment which can help the organisation take strategic decisions.
Building on Peter Drucker’s well known words, “What gets measured gets improved,” to this I add, “What gets correctly measured, gets significantly improved”
The writer is Founder Director at Leadge Business Services Pvt. Ltd.