Most companies think they know how much profit certain products bring to the table. But their real costs might be deceiving.
The complexity of activity-based costing
True product profitability is elusive. Individual products that we think are highly profitable sometimes aren’t. If you spread indirect costs evenly across the entire product portfolio, the true margins are distorted.
Typical indirect cost allocation methods look at an organization’s activities and assign a formula-derived cost to all products and services under its umbrella. As more products are added to the company’s portfolio, a clear association between products and costs becomes blurred.
Many companies are ditching this top-down approach and are instead using direct costing analysis for a clearer picture of product costs — focusing only on labor and materials. To get an accurate idea of your profitability, compare products on a direct-cost basis first. Then factor in complexity and volume. It will soon become apparent which products make the most money.
Use direct costing with 80/20
Direct costing looks at variable or incremental costs, such as the actual costs involved in manufacturing a specific product or the costs to increase production. Direct costing is best suited for temporary activities and for short-term analysis and decisions.
Breaking down incremental, variable costs for individual products and services can give you a clearer picture of their profitability — but this approach is labor-intensive. Direct costs on a particular product are easier to report and more difficult to hide.
As you consider adding new products to your portfolio, you need to understand the added costs and complexity it will create for your overall portfolio. You must also determine how much it costs to retain older products — potentially justifying their end of life. In the process, you can determine which customers generate the most revenue.
As the Pareto Principle — also known as the 80/20 rule — suggests, in most companies the top 20% of customers generate close to 80% of profits. Using analytics and insights from direct costing, you can find ways to improve the performance of the other 80% of customers. By using the Pareto Principle in tandem with the true cost of complexity, you can tailor specific actions to your portfolio and successfully raise your margins.
Use cases for direct costing
Indirect cost allocation methods lump all your customers and products into the same expense bucket. This makes it difficult to know how to best allocate your resources on the underperforming 80% of your customer population to make them more profitable. Some customers require more support than others but still buy in quantities or selections that produce profits. With a direct costing approach, you can evaluate the support costs to determine how much those customers are worth.
Direct costing insights can also help you:
Uncover true product profitability
Direct costing provides a clearer picture of the price to bring products to market and support them. In addition, it equips management with options to control margin dollars and keep overhead down.
The direct costing approach to evaluating costs lets you see through the complexity of standard accounting methods. Using direct costing in combination with data analytics helps uncover true product profitability.
Do you really know the true cost of your products? AlignAlytics can help you use analytics and insights from direct costing to improve your profitability. Reach out to me below or or follow the author link.
Author: Patrick Mosimann