More than ever, changes in the marketplace are occurring at an accelerating rate. Everyone wants more volume; however, few are able to achieve it, and still fewer achieve it profitably. Companies are now pulling back from trying to be “everything to everybody” for the sake of sheer volume. The smart ones are attempting to identify and carve out niches – distinctive markets – that are profitable in terms of return on investment and positive cash flows.

Product-line profitability is basic. From the executive’s view, product-line profitability is the starting point for most business decisions. Product pricing, promotion, and plant investment all should involve a detailed financial analysis.

In particular, product-line profitability analysis is an ideal way to diagnose a problem (or an opportunity!) in division or business-unit operations. But such analysis is meaningless without good data. Unfortunately, few business units have really good product-line profitability or budget data.

Business units without a good knowledge of those product lines that fail to earn am economic return greater than their cost of capital are unlikely to make the right investment and dis-investment decisions. The growing trend toward managing to increase shareholder value requires detailed economic return and cash flow data not typically found in traditional accounting systems. Additional economic and marketing data frequently need to be developed.

The profitability statement

Exhibit 1 (see next page) shows the basics for a simplified product-line profit ability statement. Naturally, it resembles a consolidated income statement. There are exceptions, however. The analysis can be done by year for one product line; or performance between product lines can be compared for the same time period as shown

Although most businesses measure gross profit on a product-line basis for pricing purposes, allocation of expenses is usually difficult and therefore is avoided. The fact remains that advertising, promotion, and other marketing expenses can be applied to produce a more meaningful marketing contribution for each product. More difficult but reasonable allocation assumptions must be made when selling, transportation, and corporate overhead expenses are assigned to particular product lines.

HASS is a Manager in the Management Consulting Services

division of the Chicago office of Ernst & Whinney.

Product A ProductB ProductC
Sales
Gross profit
Total expense
Net operating profit before tax

Net operating profit after tax

Assets
Accounts receivable
Inventory
Fixed assets
Other assets
Total assets

Liabilities
Accounts payable
Other liabilities
Total liabilities

Net assets
After-tax ROA
Net cash flow

EXHIBIT 1

Since tax benefits may accrue to some product lines and not to others, it is meaningful to speak of after-tax net operating profit when evaluating product-line profitability.

ROA and cash flow

For even grater insight, net assets and depreciation are allocated among product lines to produce product-line return on assets (ROA) and cash flow, as displayed below. Some companies go so far as to actually “inflation adjust” product-line asset and liability accounts

ProductA ProductB ProductC

Revenues
Cost of goods
Gross profit

Expenses
Advertising & promotion expense
Other marketing expense

Marketing contribution
Selling/commission expense
Transportation expense
Distribution/warehousing expense
Corporate allocation
Other (income) expense

Total expenses
Operating profit before tax
Income tax

Operating profit after tax


EXHIBIT 2

Receivables and payables are typically allocated as a percent of sales; they are adjusted only if there are noticeable differences in experience between product lines. Off-balance sheet assets such as leases should be included to place the product line into a more economic perspective. Other liabilities that might be assigned to a product line include deferred taxes, which might reduce net assets of one product line over another.

Net operating profit after tax divided by net assets provides after-tax ROA-a highly significant measure of performance. Net cash flow is computed by adding net operating profit, change in net assets, and depreciation. Although individual companies may define terms differently, product-line profitability analysis at all companies attempts to explain the basic economic differences between winning and losing product lines.

Once product-line profitability statements are prepared, these familiar rations can be computed (usually for the purpose of comparing performance between years or between products)

Gross profit margin = Product gross profit/ Revenues

Days sales outstanding = Accounts receivable X360/ Sales

Inventory turns = Cost of sales /Average inventory

Return on sales = Profit after tax/ Sales

Asset turnover = Sales/Net assets

Cash return on sales = Net cash flow/Sales

Like most management reporting systems there is an art to determining the proper level of detail, the proper time periods to prepare reports (typically quarterly and annually),and by whom and for what the data will be used (e.g. product managers for pricing decisions or top management for investment decisions.)

Despite the importance of product-line profitability data and the widespread availability of tools to manipulate it, managers rarely have clean economic profit data organized in a meaningful fashion. Although an excellent diagnostic tool, it is rarely developed until after a serious problem occurs, Like any diagnostic tool, it is better applied before profitability problem develop,