Last time, we talked about the importance of knowing profitability by customer, but what about the products and/or services you sell? Do you know which lines of business are the most profitable and which are the least? You may think you know where your profits are coming from, but do you really? Are you sure? For more on this, please read below.
At least once a year, it’s a good idea to put your lines of business under the microscope to confirm that they are all making the profit contributions you think they are. Even if you’ve done this at some point in the past, it’s still a good idea to do it again. After all, things change. You may have changed your pricing strategy or your cost structure may have changed or the buying patterns of your customers may have changed . . . any one of those changes could seriously impact the profitability of one, or several, or all your lines of business.
To do this analysis you’ll have to know (as you should) the variable costs (those costs, like labor and materials, that go up and down as sales rise and fall) that go into each product or service you offer. Be careful to include all your variable costs, not just labor and materials. For instance, if you pay sales commissions, those should be included. And you’ll have to know (as you should) what gross profit margin (sales revenue less variable costs) you need to cover your overhead and still produce an acceptable net profit.
Ideally, your Profit & Loss Statements are formatted so that you’re looking at gross profit by line of business each month. Unfortunately, a lot of small business P&Ls (and I’ve seen a lot of them) dump sales revenue from all lines of business into one bucket making it impossible to discern what’s making money and what’s not. In those cases, the owner/operator is depending on instinct or anecdotal evidence to decide where the money is coming from . . . not very dependable sources of business intelligence.
Knowing which lines of business turn an acceptable profit and which do not is critical to pricing and sales strategies. That’s not to say that you should automatically drop a line that’s unprofitable. If you’re using a so-called “loss leader” strategy . . . offering one product or service at little or no profit in order to stimulate your customers to buy your profitable lines . . . then it’s OK. But if you’re losing money on a line without knowing it or intending to, that’s a problem.
Understanding your company’s profitability by line of business is key to most of your important decision-making. If you struggle with knowing how to do it or where to start, call me. We should talk.