When you offer a variety of services and products, some will invariably earn you more profit than others. There’s still value in offering lower-profit products, especially if you’re new in the market or it encourages customers to buy your other products. At some point, though, it makes more sense to drop the product and refocus your efforts where there’s more potential. Here’s how to decide when that time has come.
Evaluate Product Revenue and Direct Costs
You may have a hunch that you’re losing money on a product, but it’s smart to run the numbers to make sure. First, evaluate whether product revenues cover direct product expenses. You can do this by subtracting direct costs from product revenues. As a rule of thumb, direct costs are costs that only benefit that product or wouldn’t exist if you weren’t selling the product. Manufacturing costs and payroll costs of employees dedicated to the product line are both direct costs. Specific advertising costs may be another potential direct expense.
Consider Overhead Costs
If product revenue covers direct costs, that’s good news. There are, however, other costs involved in running your business. Taxes, professional fees, salaries, business insurance, and rents that aren’t dedicated to a single product all need to be paid for somehow. If your product and service revenue only covers direct costs, your business would lose money. To account for this, you can calculate whether product revenue covers direct costs plus an appropriate percentage of overhead costs.
You need a cost allocation plan to figure out what the product’s fair share of overhead costs should be. If you want to keep it simple, you can allocate all overhead costs based on percentage of revenue. For example, if the product you’re analyzing composes 30 percent of product revenues, you can assign it 30 percent of overhead costs. If you want a more accurate allocation, try to allocate costs based on what’s truly driving the expense. For example, you may want to allocate payroll expenses based on the percentage of time that all staff dedicates to that product.
Decide to Sell or Drop
If product revenues don’t cover direct costs, or don’t cover direct costs and a percentage of overhead, it may not make sense to keep selling that product. It doesn’t automatically mean that you should drop the product though. In fact, Avondale co-founders Karl Stark and Bill Stewart point out there are lots of valid reasons to sell an unprofitable product. Before you make a decision, ask yourself these questions:
- Is there loss-leader potential? There’s an entire pricing philosophy based on pricing certain products at a loss to attract customers to more profitable products and services. Does the product or service provide a gateway for customers to buy products with a higher margin?
- What’s the immediate financial effect? The product may not be covering a share of overhead costs, but those overhead costs aren’t necessarily going to disappear if you stop selling it. Will your immediate profit increase or decrease if you drop the product?
- Is there potential to increase revenue? It takes time to sell the volume you need to completely cover your costs. Do you expect the sales level or price point for this product to increase in the future?
- How much money are you spending to create the product? Are there ways to cut costs and produce it more efficiently?
- Do you have the opportunity to sell a different service or ramp up sales on a more profitable product? Dropping the unprofitable product can free up time and resources for more rewarding endeavors.