Mix of offerings is more important to profitability than many business people realize. Mix affects sales volume, profit contribution, and costs of operations and overhead. This article explains how to look at optimizing the combination of these factors in making mix changes.
Most businesses think about selling more items or services. Why not?
Done effectively, selling or providing more of what you already offer can be a big help in creating efficiencies. But sometimes you are serving virtually all of someone's needs for those items.
The application to a for-profit organization is obvious. What else can you profitably sell or provide at a fair price with desirable qualities and service that the customers you already have want to buy? The advent of the Internet makes this evaluation much more potentially rewarding because postal, air freight, and electronic delivery choices enable you to serve most of the world with your added offerings.
This for-profit challenge requires considering the potential volume and the effects on overhead costs and profit contribution margins. Example 1 shows the profit effect that a positive change in volume can make when you grow through more profitable items that do not increase overhead costs very much.
Example 1: Adding More Profitable Items to Expand Revenues Without Increasing Overhead Costs as Rapidly Further Speeds Profit Growth
This example shows the profit multiplying potential of increasing profit contribution margins from 30 percent to 40 percent while decreasing corporate overhead costs from 20 percent to 3 percent of revenues. The result is a 7,700 percent profit solution. If revenues could be expanded even more, a 40,000% improvement (a 2,000 percent squared improvement) would result.
Annual Pro Forma Financials Before Volume Expands
Revenues $1,000,000
Cost of providing offerings $ 700,000
Profit contribution $ 300,000
Corporate overhead cost $200,000
Pretax profit $100,000
20 Times Volume Increase with Higher Profit Contribution Products and Limited Additional Overhead Expenses
Revenues $21,000,000
Cost of providing offerings $ 12,600,000
Profit contribution $ 8,400,000
Corporate overhead cost $ 600,000
Pretax profit $ 7,800,000
The challenge in making such a change is to focus on both higher profit contribution offerings and keeping overhead and operating costs low. The profit-harming mistake that many make is to only look at the contribution percentage. When that happens, the gains in profitability may be eaten up by new costs to deliver the added offerings that more than offset the profit contribution of those offerings. Exhibit 2 quantifies that point.
Example 2: Adding More Profitable Items to Expand Revenues Hurts Profits When Overhead and Waste Costs Grow Too Rapidly
The potential profit gains from higher profit contribution percentages (going from 30 percent to 40 percent in this example) can be more than offset if waste and overhead costs grow too rapidly in providing required items. Perishable, high-tech, and fashion items often have this problem as time causes value to decline, resulting in waste or markdown charges. Higher profit contribution offerings are likely to increase the administration and service costs that support them.
Annual Pro Forma Financials Before Volume Expands
Revenues $1,000,000
Cost of providing offerings $ 700,000
Profit contribution $ 300,000
Corporate overhead cost $200,000
Pretax profit $100,000
20 Times Volume Increase with Higher Profit Contribution Items and Faster Growth in Overhead and Waste Expenses
Revenues $21,000,000
Cost of providing offerings $12,600,000
Profit contribution $8,400,000
Added waste and markdowns $3,150,000
Corporate overhead cost $5,200,000
Pretax profit $50,000
How can these mistakes be avoided? Begin with small experiments where you can measure the increases in volume, profit contribution, and costs before committing to a major change in your business model.
Copyright 2007 Donald W. Mitchell, All Rights Reserved
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