Companies constantly update their products to stay ahead of the competition and maintain customer loyalty. Sales and marketing look for those new features and product modifications that can offer an edge.
But beyond the obvious costs that go into modifying your products — such as design changes, manufacturing setup and marketing campaigns — do you know the true impact of bringing new products into your operations? This continuous drive for something ‘new’ does have a significant counter effect – it brings additional complexity to the business. Without an eye on managing this complexity the business will quickly be less profitable as the number of product variants grow.
What is true profitability?
True profitability takes direct costing a few steps further. Specifically, it looks at the cost of complexity or the hidden transformation costs that occur with product proliferation. These can be found in the indirect costs and overheads. For example, new suppliers mean more work for procurement, logistics, inventory management etc. These fixed costs are rarely effectively allocated to products and therefore by definition a full picture of product profitability is difficult.
Standard financial accounting allocates these indirect costs (absorption costing) so that a full costed value of the company’s product inventory can be stated on the balance sheet. This approach will tend to overstate the profitability of the tail at the expense of key products and customers. True profitability looks for a better proxy to allocate these fixed costs, namely complexity drivers. By restating these fixed costs, based on complexity factors, the business gets a “truer” picture of which products and customers contribute profitably to the business. This then allows a more accurate view of where the tail can be cut, and the business simplified to focus on where true profits are earned.
Adding product options increases complexity
As you introduce new products or add new features to existing products, your fixed costs go up. New materials, components, vendors, and support functions increase your overhead. Every new part or variant that you add to your product portfolio drives up the cost of complexity. And you must eventually offset these increases by increasing prices or reducing costs. The alternative is to see reduced profit margins, reduced competitiveness and ability to react to changing market conditions. Managing complexity downwards is a constant battle and needs better tools to track and deliver on.
Complexity can result from:
• New parts
• Tailored parts that interfere with standard parts
• Low-volume products that hinder production of high-volume products
• Inconsistent and variable designs that impact inventory management
Too much variety can affect your business functions and customers while compromising your costs, quality, and delivery. Unfortunately, many companies approve new products and features without understanding how these new variables will affect their bottom line.
As you can see in this example, period cost (fixed costs) changes are rarely linked to new product proliferation. Looking at your contribution margin is not enough as greater complexity gets introduced into the business.
Contribution margin will be explored in a future article; SG&A expense refers to selling, general, and administrative expense.
Benefits of using true profitability
Managing the business along a dual track of a conventional P&L and a true profitability view allows for a quick understanding of where the business focus needs to occur. The tail gets reviewed with more rigour to either eliminate, find substitutes and re-price so that it doesn’t create a drag on the business. Equally more effort is placed on direct material optimization (DMO) and standardization, where possible. The business should continually looks to reassess where to trim the dead wood and re-affirm the focus to those products and customers where true profitability is earned.
Having trouble determining the true cost of your products? AlignAlytics can help you employ a direct costing approach to improve your profitability. Reach out to me below or follow the author link.
Author: Patrick Mosimann