Measuring Product Profitability: The Power and Pitfalls of Gross Profit Margin

Let’s start off with a story to show you the power of your gross profit margin: Company A sells 1,000 widgets to three customers at a 20% gross profit of $600. Company B sells 1,000 widgets to 300 customers at a 40% gross profit of $1,200. Which company is making more money?

While it seems that Company B is making more profit, a closer look shows Company B incurred operating costs of $1,000 to service its 300 customers, while Company A spent only $300 in operating costs to service its three customers. Although Company A brought in less revenue, it is more profitable with $300 in operating profit versus Company B’s $200 operating profit.

This example illustrates how misleading it can appear by looking only at gross profits and ignoring the costs associated with each product — selling, marketing, customer service, warranties, accounting, infrastructure and other overhead. Operating profits, or profits earned from the normal course of business, are what count.

The one element that is consistently ignored or misused is gross profit margin. More money is good money, right?

Gross Profit = (Total Sales) less (Cost of Goods Sold)

Your cost of goods sold is your direct cost to produce or acquire to resell your product or service (it generally includes materials costs and direct labor costs). When you express your gross profit as a percentage of your total revenue, then you get your gross profit margin.

Albeit a simple measurement, the gross profit margin has the power to destruct a business if not monitored and measured appropriately. Many companies default to only examining collective gross profits instead of measuring operating profits for each product line. The key to measuring product profitability is to analyze each product on its own, which involves allocating operating costs appropriately per product, and determining exactly what it costs to make, sell and service each one.

Gross profit is a key indicator of the following:

• Pricing: A low gross profit often indicates a company that needs to raise its pricing and quickly at that.
• Production expenses: A low gross profit margin often indicates you need to radically reduce Cost of Goods Sold, especially if you operate in a niche where you will have a tough time raising pricing. If you can’t lower Cost of Goods Sold and you can’t raise pricing, then you may need to shift out of that business niche altogether. Although scary to think about, at least it would give you the chance at being profitable. And this kind of insight is exactly what your gross profit margin gives you. More commonly, your gross profit margin will alert you to product lines you need to drop or market segments you need to ignore.
• Place (relative to benchmarks): If you’re operating at 50% gross profit margin, and your industry average is 40%, what does that tell you? The opposite scenario will tell you something vastly different.

The bottom line is that when you understand your gross profit margin you gain a simple leading indicator to help you keep an eye on profitability, production costs, pricing and cash flows.

But beware, product-by-product profitability numbers can be misunderstood. While there isn’t a minimum profitability standard for each product, oftentimes low-profit products can be equally important to your business.

As you examine your product profitability, consider these questions:

• Does a low-profit product sale lead to the sale of a high-profit product?
• Does a particularly low-profit product complete a product line?
• If a low-profit product is discontinued, will the customer go to a competitor and for possibly other high-profit products?
• What type of customer loyalty is associated with each product?
• Are customers likely to buy a product once or multiple times?
• What is the cost of making a product sale or acquiring a new customer?
• What administrative burdens come with selling a product? Think about warranty, customer service time, accounting complexities, lead time, inventory needs, the speed of obsolescence, etc.
• Are there hidden costs attributed to certain products, product lines or customers? For example, is manufacturing a certain product creating the potential for a public relations problem or is there a higher risk of a liability claim?
• How does your business compare to the benchmarks in the industry? Learning where you rank compared to your competitors will provide you insight on how to make strategic adjustments to your product lines.

The answers to these questions will help you determine whether continuing to offer a low-profit product is worthwhile to your business.

Don’t Forget Pricing

It’s wise to periodically monitor your product pricing to determine whether the price is supported by production, brand, and industry factors. What are other companies selling the same product for? Have you differentiated or positioned your product in a way that supports a higher price? Is there an intangible value to the customer that translates into a premium? Conversely, is the product commoditized to the point where a lower price might benefit your sales volume?

Product and pricing studies are significant undertakings. There are standard ways to accomplish them and trade associations are an excellent resource for benchmarking information. Invest the time and effort into these studies and you might be surprised at how a tweak here or there can make a difference in your bottom line.