Engineered Product Profit

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Companies normally have a mix of products and each product contributes to the “bottom line.” However, some of those products may actually subtract from the bottom line! This can happen when products are not properly priced. When looking at an operating statement, GAAP formatting usually lumps product revenues and then deducts the related direct costs for the production of the revenue. Direct variable costs are dependent on the actual production orders. If there are no orders for production, there are no direct costs. However, for a company to be an ongoing enterprise, it must pay ongoing costs to keep the door open. These costs are referred to as “fixed costs.” Basically, fixed costs happen on a regular basis and for regular amounts. Rent, Administrative salaries, insurance, equipment leases, etc., need to be paid whether or not any revenue is produced. However, there are hybrid costs that happen on a regular basis but can vary due to direct costs. Accountants call these costs, semi-fixed or semi-variable. Indeed, it usually requires some real study to determine those hybrid costs.

For standard GAAP operations formatting, the category “Operating costs,” can contain both fixed and semi-variable costs. However, many companies will also produce the category “General & Administrative costs” (G&A) that supposedly represent fixed “Overhead;” costs that must be paid regardless of any production.

How to allocate Overhead when it comes to pricing?

How to allocate “Overhead,” is an important question that most companies wrestle with. And this becomes very important when trying to determine what product contributions to profitability is concerned. For example, a company may have a very popular product, but that product may require an un-proportional amount of G& A time to support the product. The purchasing department may need to dedicate much of its time to purchasing raw materials and parts. Logistics may need to spend a disproportional amount of time arranging for deliveries; Insurance costs may become skewed if the product requires special handling. The accounting department or CFO may not be aware of the operational and administrative costs involved in a product. As a result, a popular product may not be priced appropriately….and in some cases could be dragging on the company’s profitability. This is the reason that managers must review the actual costs before engineering the profit margin.

Contribution margin is defined as Revenue less direct costs, but more analysis must be done to arrive at a “real contribution” margin.

Once each product is analyzed for its direct costs, it must also go through a time-consuming analysis of its actual overhead allocation. Again, we mean all costs other than direct variable costs. It also requires the identification of semi-fixed and semi-variable costs. This would require a close examination of all costs as the product moves through the production, sales and support processes.

Another important factor to consider is what is the product’s breakeven. Once a product passes its breakeven, the overhead allocation has been paid for and either the product becomes more profitable or it can be reduced in price. This is very important when it comes to planning marketing and sales initiatives.

Conclusion

Most product mix profitability reports use Gross margin as a measure of product profitability. However, this is not an accurate determination of the actual operating profit margin. Managers need to make sure that they spend the time to more carefully analyze what really makes up the “engineered profit” contribution by focusing on the all the actual costs associated with a product. The following simplified example uses a product that generates $100,000 in sales.

Engineered profit

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