This article is part one of our two part series on measuring the profitability of every product or service. Stay tuned for Part 2 which looks at what happens when you need to discount products or services as well as the importance of data and reporting.
How to measure the profitability of every product or service – Part 1
Do you know the profit margin on every product or service in your business? Perhaps you haven’t investigated it because you believe you’re making enough money overall. Or maybe you’d like to have a better grasp of product or service profitability, but just don’t know where to start.
The truth is that without knowing the profit margin on your products and services, you can’t make informed decisions about which products and services to sell, which to expand into new markets and which to eliminate. At best you may be missing out on opportunities or wasting resources, at worst you may actually be losing money on particular products and services without even realising it.
Here’s how to calculate the profit margin on individual products and services.
Understand your costs
First things first, you will need to scrutinise your costs to produce your goods and services. To get a true picture of what you’re earning you need to look at both your direct costs and your indirect costs, also known as overhead.
In the case of a product, your direct costs may include the cost of inventory or raw materials used to manufacture that product, equipment costs, transport, warehousing, import costs, currency exposure risk and direct labour costs including on-costs which are tied directly to production. For a service, your direct costs include labour directly tied to delivering that service and may also include other client deliverables.
Indirect costs, known as overhead, refer to the ongoing costs of operating your business such as marketing, indirect employee including on-costs, office space, sales, advertising, customer service, internet and so on.
Calculate gross profit
Gross profit refers to the revenue received on each product or service, minus the direct costs. The formula to calculate the gross profit on a product or service is as follows:
Revenue from Individual Product/Service – Direct Costs to Sell Individual Product/Service = Product/Service Gross Profit
For example, let’s say you sell apparel and charge $20 for a t-shirt. To understand the profit margin on that item you will need to calculate and minus the costs of selling that product from what you charge for it. Let’s say the costs of producing the product such as raw materials, manufacturing, transport, import costs and warehousing add up to $10, then your gross profit on that item is $10. See the table below.
| ITEM | COST |
| Retail price of t-shirt | $20 |
| Direct costs per unit | $10 |
| Gross profit per unit | $10 |
| Gross profit % | 50% |
However, what about the other indirect costs of doing business? Like labour, rent, marketing, admin or IT? Without understanding your indirect costs you won’t get a clear picture of your net profit.
But how should you allocate overhead to an individual product or service? Because indirect costs aren’t always specific to each product or service, you will have to calculate how much to allocate to each product.
Allocate overhead
For a basic calculation, start by adding up your total overhead. This should include all indirect costs including indirect labour costs such as the cost of wages for staff in admin, marketing and financial functions. These items are often referred to as operating expenses.
To calculate the overhead allocation rate, we need to work out what % of the total labour time in the business was taken up by t-shirts as opposed to other products, and allocate that proportion of overhead to each item.
Let’s have a deeper look:
Firstly look at the example of the t-shirt. Let’s say that your overhead for your apparel business over the course of a year equals $150,000. You produce 300 products, one of which is the t-shirt. In 12 months, you would produce 1,000 t-shirts.
It takes 400 direct labour hours to produce the 1,000 t-shirts out of a total number of direct labour hours across the business of 30,000. This means t-shirts equate to 1.33% of the total labour effort, which equates to $2.00 per unit. See the table below.
| ITEM | COST |
| Total overhead over 12 months | $150,000 |
| Overhead on t-shirts (% of total hours) | 400 / 30,000 = 1.33% |
| Overhead on t-shirts (1,000 units) | $150,000 x 1.33% = $2,000 |
| Overhead allocation rate (per t-shirt) | $2,000 / 1,000 = $2.00 |
What this means is that for every hour needed to make a t-shirt, you need to apply the overhead allocation rate of $2.00.
Calculate net profit
Now that you know your overhead per unit you can calculate your net profit. Here’s the formula:
Product/Service Gross Profit – Overhead per unit = Product/Service Net Profit
See the table below.
| ITEM | COST |
| Overhead per unit | $2 |
| Gross profit per unit | $10 |
| Net profit per unit | $10 – $2 = $8 |
You now know you’re earning $8 in net profit per item. That gives you a much more accurate picture of what you’re really earning rather than relying on gross profit per item alone.
But what happens if you need to discount stock or don’t sell all units produced? Stay tuned for part two of this two-part series on measuring the profitability of every product or service.
By Ryan Miller, CEO, Keeping Company
About Ryan Miller
Ryan is the founder and CEO of award-winning bookkeeping and accounting firm, Keeping Company. The company empowers business owners by providing bespoke bookkeeping, accounting and business advisory services which leverage the cloud.
As a business leader and entrepreneur himself, Ryan has built and grown several companies and understands the challenges that business leaders face on their growth journey. With extensive commercial experience as a CFO and director across a range of industries, Ryan is able to help clients tackle any commercial or financial challenge or opportunity.
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The material and contents provided in this publication are informative in nature only. It is not intended to be advice and you should not act specifically on the basis of this information alone. If expert assistance is required, professional advice should be obtained.