Why We Should Review for Unprofitable Products
It is quite common for only a small proportion of a company's products to generate most or all of its profits. Consequently, someone should regularly review the remaining products to see which ones are unprofitable, and so should be terminated. Engaging in this analysis can yield the following benefits:
- Production complexity can be extreme when a large number of varied items are being manufactured. Reducing the number of products reduces the amount of complexity.
- Each product typically requires its own unique raw materials, so eliminating a product will reduce the amount of raw materials inventory on hand. A downstream benefit is that the elimination of some unique raw materials will allow the company to stop using certain suppliers.
- The marketing budget can be more heavily focused on a core group of products.
- It is easier to train the staff to support customer inquiries when there are fewer products.
The Overhead Cost Reduction Conundrum
It is not sufficient to terminate a product based on a fully-loaded cost that includes an overhead allocation. Doing so merely means that the same total amount of overhead will then be allocated to the remaining products, which increases their cost. Instead, only terminate a product if its direct cost equals or exceeds its price, which will greatly reduce the number of products eliminated.
To be sure that a product cancellation is beneficial, run an estimated before-and-after income statement that reveals the impact of the change. If profits do not improve, do not cancel the product.
The Product Cancellation Analysis Formula
As stated above, direct costs are the only applicable costs to use when deciding whether to cancel a product. Consider using the following formula, which is comprised solely of direct costs:
Lowest discounted price (1)
- Commission (2)
- Material cost (3)
- Scrap cost (4)
- Outsourced processing (5)
- Inventory carrying cost (6)
- Packaging cost (7)
- Unreimbursed shipping cost (8)
- Warranty cost (9)
= Profit (loss)
Explanations of the footnoted items in the preceding formula are noted below:
- Lowest discounted price. A product may sold at a variety of discounts, so run the calculation using the lowest discounted price, to see if there is a profitability problem at that price point.
- Commission. Subtract any sales commissions paid as a result of the sale. Only use those commissions that directly relate to the sale.
- Material cost. Include the cost of any materials and production supplies directly associated with the product.
- Scrap cost. Include the amount of scrap that is reasonably expected as part of the production of a typical unit.
- Outsourced work. If any production work is handed off to a third party, include that portion of this cost that would be eliminated if the product did not exist.
- Carrying cost. Include the interest cost of the funds invested only in that inventory specifically related to the product. No other inventory carrying costs should be included, since they will not disappear if the product is eliminated (that is, the other carrying costs are overhead costs).
- Packaging cost. Include the direct cost of packaging materials used to encase and ship the product, but only if these materials are unique to the product.
- Unreimbursed shipping cost. Include the cost of shipping the product to the customer, but only if the customer does not reimburse the company for this cost.
- Warranty cost. Include the cost of warranties associated with the product, though this amount may be immaterial.
We have not included direct labor costs in the preceding calculation, since they are usually a fixed cost. If that is not the case, such as when employees are paid based on the number of units manufactured, then include this cost in the calculation.
Reasons to Retain Unprofitable Products
There are several reasons why management may elect to keep products that are not profitable. Consider the following situations:
- Remaining raw materials. There may be a fair amount of raw materials on hand that only relate to the product in question, so management wants to draw down these quantities via additional product sales.
- Hole in product line. It may be important to present a complete lineup of products to customers, to keep them from trying the wares of a competitor if there is a hole in the product line.
- Market blocking. Retaining a product at a low price point may keep competitors from entering the market with their own products.
- Required by customers. Some customers may need the unprofitable product, and their total purchases from the company are so profitable that they can subsidize the product.
- Dependent products. There may be dependent products that provide outsized profits that completely offset any losses incurred by the main product. Thus, cell phone accessories can offset losses incurred from sale of the phone itself.