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True Profitability

The reason why so many companies lose money with the long tail (the low-volume and highly diversified part of the product portfolio) is that they fail to define, measure, and govern complexity. Managers rarely know the pocket money or the free cash they get to keep (or let go) when they sell a specific product or a service. They only see the contribution or gross margin earned, but seldom understand the final profit or loss from every product or transaction. Monthly income statements deliver consolidated financials, but they do not help to make decisions related to individual SKUs.

General accounting is intended to focus on the financial stakeholder’s community. It’s not designed to give you the ability to manage complexity or recognize the portion of complexity costs owned by each product or service. For the most part, standard accounting accumulates the overhead into one or more buckets, but it cannot differentiate or apportion the actual amount of cost to each product. All it can do is to allocate some of the expenses based on pre-defined rules or standards.

In many instances, accounting distributes the indirect costs across all products in proportion to revenues, leaving out the cost nuances between bestsellers and laggards. If the business is making money as a whole, a standard report may lead us to think that “all business is good business,” as long as they have acceptable gross margins.

Different products and services can carry very different amounts of overhead, in the form of associated support and complexity costs. Not knowing the value of indirect expenses that go with each SKU can lead to some very wrong decisions, especially concerning the long tail. The cost of highly engineered and manufactured modifications varies significantly depending on testing, sourcing, and support requirements. Even similar products can have considerably different bottom-lines, depending on production volumes, production lines, and target markets.

One can appreciate the profit imbalance among products by applying Pareto thinking. The vast majority of items in any portfolio generate only a small amount of profit and sales dollars (“twenty” percent). However, these products are also responsible for creating most of the overhead (“eighty” percent). The long tail items carry a significant amount of complexity cost.

When it comes to spreading the overhead, like ESG&A (engineering, sales & marketing, general and administrative overhead), accounting is at a loss. These costs remain unassociated with products since functions or departments are responsible for them. We would have to break-down each associated activity of the engineering department, for example, with a specific product during a period. The closest cost accounting method to propose a solution for this massive task is activity-based costing or ABC.

However, like conventional accounting, ABC is very dependent on estimates and is prone to inaccuracies. ABC is also expensive to implement, and its data is likely to be misinterpreted. The sheer number of steps, time, and resources involved in mapping the entire portfolio of a company can be daunting, leading to shortcuts and mistakes. If applied to only a few targeted products or processes, ABC can be a useful tool for a short-lived picture but, if you have thousands of products and customers in a dynamic market environment, you may want to stay away from this method. To manage product variety, you need a more straightforward and cost-effective way. You need to know the True Profitability of every SKU you sell.

True Profitability is pure profit devoid of arbitrary allocations or interpretations created by conventional accounting systems. It starts with the contribution margin and ends with the free cash generated. Said differently, True Profitability is “money in the pocket.” It’s the equivalent of having an income statement for each product or service. If an SKU is not lucrative from a True Profitability standpoint, it will reduce the overall company’s earnings by a certain amount. We call these products “freeloaders” since they don’t carry their weight and survive thanks to other items. You can afford to have some freeloaders if you know that they will either attract new customers or sell more of your existing profitable products. In most cases, companies don’t even know they have freeloaders, let alone having a conscious strategy to use them to expand profits.

Amazon has a name for freeloaders or products with low or negative true profitability. They call these items CRaP inside the company, short for “Can’t Realize a Profit.” Typically, CRaP is used to refer to products with thin margins that use a lot of indirect overhead, mostly warehouse space, and handling costs. Very heavy or bulky items, costly to ship, must have a higher contribution margin, to show an acceptable True Profitability. For instance, packaged high-volume and low-margin goods, such as purified water or soda cases, can be considered CRaP.

Despite all the discipline and structure around new product introduction, most decisions impacting the portfolio are carried on by managers without a reasonable understanding of True Profitability. Typical metrics include ROI (Return on Investment) and NPV (Net Present Value), together with factors like risk-adjusted NPV and time-to-market. On top of not knowing True Profitability, more projects fail to reach ROI and NPV targets because of incorrect volume and margin predictions than any other factor.

Managers rely too much on questionable assumptions and too little on portfolio analytics and modeling. When a new product launch goes wrong, companies take too long to correct the problem, under the influence of the different paradigms, including the sank cost one. In the meantime, freeloaders are eating away free cash flow and operating profits. To make proper and fast decisions, managers need a better, more practical way to arrive at the item’s P&L. Nevertheless, how can managers calculate the True Profitability of a product or service?

First, remember that our collective knowledge (and the Pareto rule) tells us that twenty percent of the products (or customers) account for eighty percent of the profits. We also know by experience that the remaining products (the trivial many) are responsible for eighty percent of the complexity costs. The proportions are never precisely 80:20, but, in reality, there is always a significant imbalance between efforts and results. The reason for this imbalance is because complexity costs increase with the levels of variety and activity.

Companies typically spend more money with the losers than they spend with the winners. Not only because they believe they will turn the losers into winners, but primarily because they don’t measure the drivers of complexity. If we were to distribute the actual overhead between the eighty and twenty, using a direct cost attribution method, the picture would look very different than the one presented by general accounting, leading us to understand why some business is not so good.

True Profitability is the difference between Contribution Margin and Complexity Cost. You can arrive at the complexity cost by distributing the total overhead in proportion to a product’s economic value and activity. In other words, the share of the total indirect cost owned by a product depends on where it falls in the long tail curve and how much activity is associated with that specific product or service. Sales transactions, part count, and even revenues can all represent activity. Complex and labor-intensive operations will always cost more. On the other hand, simple and effortless will invariably yield lower overhead and higher economic value.

Contribution margin is the result of subtracting the variable cost from the sales price. It measures the amount that individual products or services contribute to net profit. The ability of a company to have a robust free cash flow from a product or service starts with sound contribution margins. There is little or nothing managers can do to improve profitability if contribution margins are negligible. Moreover, contribution margin represents a clean ratio between price, which is defined by the market, and direct cost, which is achieved by the company’s capabilities. It’s the purest indicator of economic performance and value that we can find in a business. Everything else is abstraction and convention.

However, contribution margin alone does not represent the ultimate profitability of a business. True Profitability does. When we accumulate the True Profitability from each SKU, using Pareto, we can see a more realistic picture, in line with what we see in the company’s income statement. As per the figure below, the distribution of complexity costs in proportion to activity and economic value, allows us to realize that we have underestimated the importance of products at the head of the curve and overestimated the profitability of the ones at the long tail.

The True Profitability Curve

Like the cumulative contribution margin, the line that represents True Profitability increases sharply in the head area of the demand curve. However, as we get closer to the tail of the portfolio, we see a sharp decline to the bottom-line, weighted down by the cost of complexity attributed to long tail products, mainly the freeloaders. Companies can have a much clearer picture of portfolio profitability if they use the long tail curve and the level of transactions of a given product to apportion the overhead, compared to conventional accounting allocations.

Knowing which products help or hurt the company’s profitability is very important. The question then becomes: how can managers lift True Profitability and reduce the gap with the contribution margin? The first step is to challenge freeloaders or low profitability items in the company’s product offering. It requires data and management courage to deal with the inflection points and bad clusters in the True Profitability curve. Just by phasing out, replacing or pricing up freeloaders, we can have an immediate positive impact on the business.

Once we deal with freeloaders, we turn our attention to products and services that must remain in our offering, for various reasons, but still show unsatisfactory True Profitability. Items we cannot discontinue, replace, or raise prices right away. These are “sick products” that need healing. Managers turn their attention to internal complexity and use standardization and other tactics to heal sick products. We deal with internal complexity by physically separating the production of eighty and twenty products, increasing the level of parts similarity in the bill of materials, reducing part count and optimizing direct material cost, for example. We also work on supply-base rationalization and evolve the product line architecture to become more modular. These are some examples of the types of strategies used to heal the portfolio.

Lastly, companies need a process to govern and manage the long tail, to be able to retake variety as a useful growth tool while preventing low-margin products from entering and remaining in the portfolio. Profitably growing the long tail requires engaged people and reliable information. Managers need constant and easy access to True Profitability to be able to separate “CraP” from winners.

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