This article is part two of our two-part series on measuring the profitability of every product or service. Check out part one here which looks at how to calculate gross and net profit and allocate overhead.
In part one of this article series we looked at how to calculate your gross profit on a product or service and how to allocate overhead effectively to calculate your net profit on a product or service.
We looked at the example of a t-shirt which retails for $20 with a net profit of $8 per item. But how can we understand what the t-shirt product line is actually worth year on year?
What is a product or service line actually worth?
To understand the value of a product or service line you will want to look at the numbers at a more macro level. Start by looking at the revenue from all units sold over 12 months.
| ITEM | COST |
| Retail price of t-shirt | $20 |
| Units produced in 12 months | 1,000 |
| Units sold in 12 months | 1,000 |
| Total revenue from t-shirts | $20,000 |
| Direct costs for 1,000 units | $10,000 |
| Gross profit for 1,000 units | $10,000 |
| Overhead | $2,000 |
| Net profit for 1,000 units | $8,000 |
You’re earning $20,000 on your topline and $8,000 on your bottom line on this product line. How does this compare to your other products? It’s a good idea to analyse the performance of every product to see which are under or overperforming.
What if you don’t sell every unit or need to discount items?
The above table makes the assumption that you will sell every item at full price, but as we all know this is most likely unrealistic. What happens to your calculations if you need to discount items at various points to move them? See the table below.
| ITEM | COST |
| Retail price of t-shirt | $20 |
| Units produced in 12 months | 1,000 |
| Units sold at full price in 12 months | 600 x $20 = $12,000 |
| Units sold in regular sale at 20% discount | 250 x $16 = $4,000 |
| Units sold at end of season clearance sale at 50% discount | 150 x $10= $1,500 |
| Total revenue from t-shirts | $17,500 |
| Direct costs for 1,000 units | $10,000 |
| Gross profit for 1,000 units | $7,500 |
| Overhead | $2,000 |
| Net profit for 1,000 units | $5,500 |
In this case you had to sell 250 units at a 20% discount and 150 units at a 50% discount. That reduced your total revenue to $17,500 and net profit to $5,500. So, you can see you’re still earning a return. But to understand how decent, there’s one more step to take.
Calculate net profit margin as a %
To get a clearer idea of profitability you’ll want to calculate your net profit margin as a percentage of total revenue on that item. The formula is as follows:
Product Net Profit / Total revenue on item = Net profit margin (%)
See the table below.
| ITEM | COST |
| Total revenue from t-shirts | $17,500 |
| Gross profit for 1,000 units | $7,500 |
| Net profit for 1,000 units | $5,500 |
| Net profit % | 31% |
You now know that you’re achieving 31% net profitability on your t-shirts. To understand whether that is above or below the industry benchmark standard, do some research into what profit margins you should expect in your industry. This will arm you with the right information to understand how the product or service compares to others, whether it is a good one to invest in or expand, or whether it’s time to withdraw it from the market. The ATO publishes benchmarks for small businesses which could be a useful place to start.
The importance of accurate data and reporting
It’s one thing to understand how to calculate your profitability on each product or service, it’s another thing to actually spend the time and energy doing it. Getting this right takes time and an investment in establishing the right systems and detailed reporting. However, once you’ve made that investment and have access to this data, it will be a turning point for your business.
One thing to keep in mind is that the more detailed and tailored your overhead allocation, the better. One of the ways businesses trip up when it comes to calculating overhead on each product or service is by keeping things too broad which can impact accuracy.
For example, instead of dividing your marketing costs equally between your products and services, if you know how your marketing spend has been divided between products or services (for example, if you know exactly how much you spent on advertising a particular product on social media) you should reflect this in your calculations.
Unfortunately most businesses don’t understand things at this granular level. If this is the case for your business, it’s ok to start with a broader picture and build in greater detail over time as you improve your data collection, systems and reporting. Working with an experienced and knowledgeable accounting firm to expedite this process for you can make an enormous difference.
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.
At Keeping Company, we’re not just accountants, we’re business people too. With our counsel, your business can reach its full potential.
We have a team of experts; Cloud Accountants, Business Advisors, Finance Specialists working together and ready to help, contact us today.
For all media enquires please contact Tracy Miller, CMO, Keeping Company 0414 898 452.
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.