This isn’t a new sales technique or piece of software. Just me sharing some insight about how accounting can help you increase your profit, by working out which of your products/services make money and which ones lose money. In a business selling more than one product, we need to analyse the figures in more detail than the Profit & Loss Statement (P&L) allows. Accountants use job costing (a.k.a. Activity Based Costing) to do this. But first let’s start with some general accounting concepts.
The revenue, or turnover, figure in the P&L shows us the grand total of all sales transactions. Depending on the business, these sales could be products or services, across a number of stores, projects or clients. We can also calculate the overall margin using the figures in the P&L. Margin is expressed as a percentage of revenue. The gross margin is the gross profit (sales less costs directly related to the sale) divided by sales. The net margin is the total profit divided by sales. Margin is not the same as mark up.
To discuss the concept of mark up v margin let’s use an example. We’ll assume this business makes and sells robots, much more topical than widgets. The business owner has calculated that they need to make a 30% gross margin on their sales to cover overheads. So, the sales person marks up $1,000 of direct costs by 30% and sells a robot for $1,300. However, mark up doesn’t equal margin, the gross margin on the robot is actually 23% not 30% ($1,300 – $1,000 = $300 / $1,300). Understanding mark up v margin is important to ensure the terminology is correct, however it doesn’t identify how profit can be improved.
To get a true picture of where the profit is made, sales must be broken down to a lower level. Sticking with our example, let’s assume the business has three types of robot: basic, premium and deluxe. Higher level models have extra features, meaning additional sales effort is needed. The basic model is simple so the sales process is quite straightforward. The premium version has a few more features, so it’s is a bit more complicated and it takes a while to explain everything to the customer. The deluxe version is completely customised. It also includes ongoing maintenance and updates. This all needs to be factored in when calculating the profit on each type of model.
Accountants use Activity Based Costing (ABC) for this purpose. The first step in the ABC process is to group the costs associated with each activity into various buckets, for example: pre sales; production; and maintenance. Then, they calculate the hours that will be spent on each activity. The costs divided by the hours gives a $ / hour figure. These costs, sometimes called indirect costs, can be allocated to the various products/services to demonstrate the overall profit of each category. They can be combined with direct costs to calculate appropriate target margins for different types of work. This allows for a more sophisticated approach to pricing rather than targeting a generic gross profit margin.
Going back to our example business, after applying ABC to calculate the indirect cost of the sales and maintenance activities, the Accountant calculates that the breakeven price for the deluxe model is $1,500. The deluxe model currently retails for $1,300, losing them $200 per sale. This presents the business with a strategic decision: increase their deluxe model price or conversely, stop selling the deluxe model and re-focus their effort on the lower end models which are more profitable.
The fact that the deluxe model is losing money is not obvious from the P&L because the reported profit is the amalgamation of the profits and losses across all products. The P&L doesn’t allow us to see which products are our top performers and which products are costing us time and therefore money. Applying Activity Based Costing is one way accountants can provide businesses with information to identify and inform the strategic decisions all business owners face.