Growth often brings complexity. 

As a business expands, its operations become more challenging to follow from an operations and transaction level to deliver diverse products or services, each contributing differently to the bottom line. Here, complexity creeps in and distorts what was once clear and straightforward. Many business owners reach a point of frustration where the numbers clearly no longer depict reality or help them use the numbers to make decisions and grow their organization.

Rather than surrender and default to using intuition to run their business, several steps could and should be taken to help bring back the clarity they need to understand the profitability of each product or service. 

Step 1: Grasping the Fundamentals of Profitability Understanding Key Metrics 

Understanding profitability isn't just about looking at your total sales. It's really important to dig into specific numbers that tell you more about how your business is doing. Think of these numbers like a health check-up for your business.

First, there's the gross profit margin. This is like looking at how much money you have left after you've paid for the things you sell. It's a quick way to see if you're making enough money from your products.

Next is the net profit margin. This one takes a broader look, considering all the costs of running your business, like rent, salaries, and other expenses. It tells you how much money you're actually keeping as profit after everything is paid off.

Lastly, there's the contribution margin. This number helps you understand how much money each product or service is really bringing in after you take away the costs directly linked to making that product or service. It's a great way to see which parts of your business are really making you money.

Conducting a Product/Service Audit 

A thorough audit or review of your offerings is vital. This involves evaluating each product or service based on its costs (both direct and indirect), revenue generated, and market demand. Such an audit helps identify which products/services are stars, contributing significantly to profits, and which are laggards, perhaps draining resources.

Step 2: Implementing Cost Analysis Techniques Distinguishing Fixed and Variable Costs 

Understanding and separating out the nature of your costs is crucial. Fixed costs, like rent and salaries, remain constant regardless of sales volume. Variable costs, such as materials and production labor, fluctuate with sales. This distinction aids in accurately determining product/service profitability.

When determining breakeven in the number of customers or orders, fixed and variable costs are key aspects of the total equation. This analysis also helps you understand which costs increase and which don’t when you sell more.

Embrace Driver Based Analysis 

Driver Based Analysis offers a more nuanced approach to analyzing assigning costs, especially in complex operations. 

1. Start with a Clear Understanding of Your Business: Understand what drives your sales, costs, and margins. This could vary greatly depending on the nature of your business.

2. Use Simple Tools: Small businesses don't necessarily need sophisticated software. A well-structured spreadsheet can be a good starting point.

3. Regular Updates and Reviews: The effectiveness of this model depends on how frequently it’s updated with actual data and reviewed for insights.

Step 3: Utilizing Data for Decision-Making, Data-Driven Insights 

In today’s digital age, leveraging data is a must. Utilize your business's data to make informed decisions about product development, pricing strategies, and market positioning. Analyze sales trends, customer feedback, and market research to understand what drives profitability in your offerings.

Investing in the Right Tools 

Invest in robust analytics tools that can handle complex data sets and provide actionable insights. Tools that integrate with your existing systems (like CRM and QB/ERP) can offer a comprehensive view of your profitability landscape.

Step 4: Adapting and Evolving Regular Review and Adaptation 

Profitability analysis is not a one-time exercise. Regularly review your product/service portfolio, adapting as necessary based on market changes, customer preferences, and internal business shifts.

Building a Culture of Continuous Improvement 

Foster a culture that values data, insights, and continuous improvement. Encourage your team to contribute ideas for efficiency and profitability enhancements.

Understanding product and service profitability is essential to ensure sustainable success as your business grows and becomes more complex. By following these steps, you can gain a deeper insight into your operations, make informed decisions, and steer your business toward greater profitability and growth.

If you need help with or want to learn more about the concepts above, reach out for a free consultation.

Ben Wann is the owner of CFO Consultants. Learn more at CFOConsultants.net.