Any product and service is initially priced to generate a profit. However, as time passes and both price points and costs change, companies tend to lose sight of the true profitability of their products. Pareto analysis holds that 80 percent of the activity in a given situation is caused by 20 percent of the population. This rule is strongly applicable to the profitability of a company’s products, where 80 percent of the total profit is generated by 20 percent of the products. Of the remaining 80 percent of the product population, it is reasonable to assume that some make no profit at all!
Consequently, financial analysis should encompass the regularly scheduled review of all company product offerings to determine which products should be withdrawn from the marketplace. This post addresses the circumstances under which unprofitable products should be cancelled. This is a valuable analysis for the following reasons:
- Complexity. In general, too many products lead to an excessive degree of system complexity within a company in order to support those products.
- Excessive inventory. Each inventory item usually contains some unique parts, which require additional storage space in the warehouse, as well as a working capital investment in those parts, and the risk of eventual obsolescence. Further, the presence of unique parts in a product may be the sole reason why the purchasing department continues to deal with a supplier; canceling the product allows the company to reduce the number of suppliers it uses, thereby gaining greater volume discounts with the remaining suppliers.
- Engineering time. If there are changes to products, the engineering staff must update the bill of material and labor routing records, all of which takes time.
- Marketing literature. The marketing department usually maintains a unique set of literature for each product, which requires periodic updating and reprinting.
- Servicing cost. The customer support staff must be trained in the unique features of each product, so they can adequately answer customer questions.
- Warranty cost. Some products have a considerable warranty cost, possibly due to design flaws or inadequate materials that require sizeable warranty reserves.
When conducting a product withdrawal analysis, care must be taken not to assume that some expenses will be eliminated along with a product. Instead, an expense may have been allocated to a product, but will still remain once the product is gone. For example: The servicing cost of the customer support staff is unlikely to result in the actual elimination of a customer support position just because a single product has been canceled. Instead, customer support overhead will now be assigned to the smaller remaining pool of products. Thus it is extremely important to only include direct costs in a product withdrawal analysis and exclude any overhead allocations. To be certain that a product cancellation is not merely shifting overhead costs elsewhere; it is useful to develop before-and-after pro forma financial statements to see if there is really an improvement in profitability resulting from the cancellation.
As just noted, these are only direct costs should be used in calculating the profitability of a product for purposes of the cancellation decision. This results in the following formula:
Standard list price (1)
– Commission (2)
– Buyer discounts (3)
– Material cost (4)
– Scrap cost (5)
– Outsourced processing (6)
– Inventory carrying cost (7)
– Packaging cost (8)
– Unreimbursed shipping cost (9)
– Warranty cost (10)
= Profit [Loss]
Comments regarding this formula are as follows:
(1) Standard list price. If a product has a number of prices based on volume discounts or other criteria, it may be necessary to create a model using the costs itemized in the model to determine the breakeven price below which no profit is earned. The result may be a decision not necessarily to cancel the product, but rather to not sell it at less than a certain discounted price, below which it makes no profit.
(2) Commission. Salespeople sometimes earn a commission on product sales. If these commissions are clearly identifiable with a specific product and will not be earned if the product is not sold, then include the commission in the product cost.
(3) Buyer discounts. The inclusion of buyer discounts in the calculation calls for some judgment. It should not be included if discounts are a rare event and comprise only a small dollar amount. If discounts are common, then calculate an average discount amount and deduct it from the standard list price.
(4) Material cost. This is the cost of any materials included in the manufacture of a product.
(5) Scrap cost. If a standard amount of scrap can be expected as part of the production process that is specifically identifiable with a product, then include this cost in the profitability calculation.
(6) Outsourced processing. If any production work related to the product is completed by an outside entity, then the cost of this work should be included in the calculation on the grounds that the entire cost of the outsourced processing will be eliminated along with the product.
(7) Inventory carrying cost. This should only be the incremental inventory carrying cost, which is usually only the interest cost of the company’s investment in inventory specifically related to the product. It should not include the cost of warehouse storage space or insurance, since both of these costs are fixed in the short term and are unlikely to change as a result of the elimination of a single product. For example, a company may lease a warehouse and is obligated to make monthly lease payments irrespective of the amount of storage space being taken by inventory used for a specific product.
(8) Packaging cost. Include the cost of any packaging materials used to contain and ship the product, but only if those materials cannot be used for other products.
(9) Unreimbursed shipping cost. If the company is absorbing the cost of shipments to customers, then include this cost, net of volume discounts from the shipper.
(10) Warranty cost. Though normally a small expense on a per-unit basis, an improperly designed product or one that includes low-quality parts may have an extremely high average warranty cost. If significant, this cost should be included in the profitability analysis.
Production labor costs are not included in this calculation!
The reason is that production labor rarely varies directly with the level of production; instead, a fixed number of workers will be in the production area every day, irrespective of the level of work performed. Thus the cancellation of a product will not impact the number of workers employed. However, if a product cancellation will result in the verifiable and immediate elimination of labor positions, then the incremental cost of the eliminated labor should be included in the calculation.
In some cases, financial analysis reveals that some products are unprofitable, but management chooses to keep the products for a limited period of time in order to use up remaining stocks of inventory:
- If so, it is useful to include the prospective effect of the cancellation in the upcoming budgeting period, as of the date on which cancellation is anticipated.
- To ensure that planned product withdrawals are included in any new budgets, consider including in the budgeting procedure a formal step to investigate any pending product cancellations.
Another consideration is that an unprofitable product may be of critical importance to customers:
- If so, it may be useful to offer an upgrade path to another [presumably more profitable] product that provides them with the required level of functionality.
- If there is no obvious replacement, the product cancellation process is likely to be greatly prolonged until a new upgrade product can be readied for service.
Even if a product is clearly unprofitable, it may be needed by a key customer that orders other, more profitable products from the company:
- If so, combine the profits of all sales made to that customer to ensure that the net combined profit is sufficiently high to warrant the retention of the unprofitable product.
- If this is not the case, consider canceling the unprofitable product and negotiating with the customer for a price reduction on other products in order to retain the customer.
Another cancelation issue is the presence of dependent products. There may be ancillary products that are supplements to the main product and that provide additional profits to the overall product line. For example: The profit margin on a cell phone may be negative, but there may be a sufficiently high profit level on extra cell phone batteries, car chargers, headsets, and phone covers to more than offset the loss on the initial product sale. In these cases, the margins on all ancillary products should be included in the profitability analysis.
Finally, the frequency of product profitability reviews will be greatly dependent upon product life cycles. If products have very short life cycles, then sales levels will drop rapidly once products enter the decline phase of their life cycles, potentially leaving the company with large stocks of excess inventory. In these situations, it is critical to conduct frequent reviews in order to keep a company’s investment in working capital from becoming excessive.
There are also two nonfinancial reasons for retaining unprofitable products that must be considered before canceling a product:
- First, a company may want to offer to customers a full range of product offerings, so they can purchase anything they need from the company, without having to go to a competitor. This may require the retention of a product whose absence would otherwise create a hole in the corporate product line.
- Second, it may be necessary to offer a product in a specific market niche in order to keep competitors from entering a market that the company considers to be crucial to its ongoing viability.
This post has focused on the incremental profitability of products and services, which may result in a rational decision to eliminate products or services in order to prevent losses. However, this can result in resistance from the marketing department, which believes in a broad base of product offerings in order to achieve the highest level of revenue—not profits. To eliminate this resistance, the marketing staff must be reoriented toward the generation of adequate profits, perhaps through the use of a profit-based bonus plan. This approach will gain their support for product cancellation decisions that may increase profits at the price of reduced revenues.