Every small business should take advantage of the resources provided by their local SCORE office or Small Business Development Center (SBDC), which are often free. One of their most common suggestions is to understand your product-level profitability. If you don’t know which products are contributing to – or undermining – your profitability, it’s difficult to make informed decisions about your product selection, pricing, promotions, and merchandising.
The challenge is that this process can be very time-consuming and tedious. But it doesn’t have to be. With the right tool and a practical methodology, you can quickly start improving your profitability.
“Perfection is the Enemy of Good”
The first step is to get into the right mindset to do an effective profitability analysis. Many small business owners avoid starting this project because it’s too daunting, while others strive for perfect information on every product. Neither approach is beneficial, sustainable or necessary.
The goals are to be directionally accurate and focus on your most important products. Start with the low-hanging fruit and stop as soon as you sense your time investment is no longer delivering incrementally better insights.
For example, if you understand the profitability of your best-selling product, any changes you make related to this product will have a meaningful impact on your overall profitability. Same thing for your second best product, except slightly less so. After you get through the products that represent half your revenues, you’ll probably find it’s not worth the additional investment of your time.
Clearly Define Your Sales and Cost Metrics
Profitability is simply sales minus cost. However, there are different definitions of each term based on industry and context. The most important action to take is to have a clear and consistent definition of sales and cost for the purpose of profitability analysis. Without this, you’ll end up wasting time and making poor decisions.
“Sales” (or “revenue”) is generally easier to define. For small businesses, the ambiguity typically centers around whether to count service charges as sales, as well as commissions paid to delivery services. Since profitability analysis does not need to follow accounting standards, do whatever makes sense for your business. (Generally speaking, if service charges are distributed to employees as tips, exclude them. Delivery commissions should typically be excluded as well.)
“Cost” (or “expense”) has more ambiguity, but the general rule of thumb is to include all of the costs directly related to the acquisition or production of your products. If you sell t-shirts, your cost is simply the amount you paid your supplier for that t-shirt. If you make custom t-shirts, your cost would be the t-shirt cost plus the cost of supplies to customize it plus the labor cost for the customization work. Just note that you typically exclude any fixed costs for the business such as rent and utilities, as well as any general expenses such as marketing.
For those familiar with accounting terms, this approach calculates gross profit by subtracting the cost of goods sold from revenue. But again, this is not an accounting exercise so define these terms so they make sense for your business. Just be consistent.
Identify benchmarks
One advantage of using standardized definitions is that it is easier to find general industry benchmarks for comparison purposes. Tapping the expertise of your local SBDC could be very helpful in defining realistic benchmarks for your specific business.
In the end, your most important and useful benchmark will likely be your past performance. Every business strives to continually improve its performance, so using your past profitability as a benchmark will help measure your progress.
Start Simple
Note: The following methodology is based on the design of the profitability analysis feature of the Manage My Business app. Feel free to use any profitability analysis tool (including spreadsheets), but this app makes it very easy to measure and track your profitability.
The premise of this methodology is that doing a profitability analysis on every product just doesn’t make sense. The best approach is to come up with an intelligent estimate of your Cost of Sales ratio for the business overall, as well as for each category. You can then focus your time on doing a deep dive estimating the cost of your most important products.
The first step is to determine the overall profitability of your business. This can be as easy as asking your accountant what your current gross profit margin is. Or just divide your total costs by your overall sales (using the definitions you determined above).
The second step is to define your category-level profitability for categories that are noticeably different from your overall profitability. For example, if you own a coffee shop, the cost of coffee products is perhaps 2-3X higher than bottled drinks. So determining the category-level profitability for bottled drinks (Diet Coke, juice, water, etc.) will make your profitability analysis more accurate.
The third step is to determine the profitability of your most important product (as described below), and then your second most important product, etc. until you stop seeing meaningful change in the profitability analysis. Remember, “good enough” is much better than perfect.
Calculating Product Cost
Determining the cost of a t-shirt or bottle of water is easy, but what about a cupcake? Let’s walk through this example to highlight where shortcuts can be taken to estimate costs.
Cupcakes are made in batches, so let’s say a recipe produces a batch of 100 cupcakes. Using the recipe, add up the current cost of each ingredient and divide the total by 100 to get the per-cupcake ingredient cost.
If you make different flavors of cupcakes and the recipes vary widely, perhaps do this exercise for three of the most popular cupcakes and average the cost. Or average the cost of the most expensive and least expensive cupcakes. It’s easy to see how precision is unattainable, but it’s also unnecessary. Just get reasonably close to a good estimate. You can always refine this later.
Labor costs should be included as well. Estimate the time it takes to make a batch of cupcakes from start to finish, excluding any idle time (such as baking time or cooling time) that could be used for other tasks. Convert this time to hours (or partial hours) and multiply it by your average hourly pay rate for a baker. And then divide by 100 to get the per cupcake labor cost. Add this to the cost of your ingredients to get your total cost per cupcake.
One additional layer of complexity exists for products with variable prices, such as a latte. The cost will vary based on the cup size, as well as factors such as extra shots, flavors, or specialty milks. The recommendation in this case is to calculate the cost of the “average” latte (whatever that would be for your business) or to define cost as a percentage of the product’s price. For example, if your average latte is priced at $5.00, you may determine your average cost is $1.50. Or, you could determine that your average cost for lattes is 30% of the price, so a $6.00 latte would have a calculated cost of $1.80 (30% of $6.00) and a $4.00 latte would have a cost of $1.20 (30% of $4.00). Use whichever approach is easiest.
One final recommendation is to take notes on how you calculated each cost so you can replicate this process in the future – because costs change and you will need to repeat this process from time to time. The first time is by far the hardest, but you can make subsequent estimates much easier and more consistent by documenting your assumptions.
Analyze Your Profitability
You should be able to get to this point for your Top 5 products in an hour or two. If you’re finding it takes longer than that, start making more ballpark estimates and come back later to do a more detailed estimate. Once you start seeing the profitability trends for your top products, you will be motivated to do more because of the great insights you find – and you’ll also start to learn where more (or less) accuracy is needed for your products.
Before looking at any graphs, you’ve probably already uncovered some very interesting insights just from the process of determining your costs. In the cupcake example above, you might have found that one ingredient (like vanilla) has a significant impact on the cost. This could lead to ideas for adjusting the recipe or finding alternative ingredients/suppliers to reduce this cost (ideally without impacting product quality). Or perhaps there are ways to reduce the labor costs by simplifying steps or investing in different equipment (such as larger mixers to make larger batches). Regardless, the biggest value from profitability analysis is going through this costing exercise and coming up with ideas to improve your profitability.
Visualizing your profitability is also a useful way to gain fresh insights. A Profit Margin heatmap will show if there are specific times of the day or days of the week that are more profitable. A restaurant may find their breakfast orders are wildly profitable but they actually lose money during the lunch hour. Or there may not be any noticeable variations. It really depends on your business. In the example below, you can see that this business is more profitable in the mornings, especially during the week.
Trend graphs are most useful after you’ve updated your costs at least once after your initial estimate. For example, if your costs are rising over a few months, you will see your profit margin shrinking over that same time period. This graph becomes a good indicator of when to consider raising the price of that product. In this example, you can see the profit margin was falling due to rising costs until a price increase returned it back a more normal level.
Next Steps
As mentioned above, repeat this process on a regular basis (perhaps quarterly) and include more product-level cost estimates over time. Costs are changing rapidly right now, so a year-old estimate probably isn’t relevant today (except for comparison purposes). Remain focused on your key products and make updates whenever a significant change occurs to the underlying costs.
