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In our previous post, we presented the following question:

Your business is losing money every month. You are going to use the last of your resources to market ONE of your three products to bring the business back to profitability. Fail and you run out of cash and go bankrupt. No pressure!

Your accountant pulled the following financial data to guide you to a decision. Which product are you going to promote?

ProductRevenueC.O.G.S.Gross ProfitGross Margin
A$20,000$10,000$10,00050%
B$10,000$2,000$8,00080%
C$30,000$10,000$20,00067%

If you haven’t already, select your answer.

The most common answer is to promote product B, and the logic is that it has the lowest COGS (money you need to put out to produce it) and the highest gross margin. Perfectly logical.

The second most common answer is product C. You make more gross profit per sale. Perfectly logical as well.

This quiz is based on an actual situation I had with a prospective client. They were losing money every month and had decided to throw a hail mary pass and promote product B. Their Controller had identified it as their ‘most profitable product’.

I suggested they not do this and predicted that if they did they would have their worst month ever. I was politely shown the door.

Two months later, the CEO called me and told me that the promotion had been a disaster, and he asked me how I had known it would turn out that way.

Here’s what I pointed out to him:

  1. They need to generate $4500 per day in Gross Profit to break even.
  2. They can only produce one product at a time in their shop.
  3. Product A takes 2 days to produce, B takes 2 days, and C takes 5 days.

If we add this information to our table, it looks like this:

ProductRevenueC.O.G.S.Gross
Profit
Gross
Margin
DaysGP per Day
A$20,000$10,000$10,00050%2$5,000
B$10,000$2,000$8,00080%2$4,000
C$30,000$10,000$20,00067%5$4,000

The right thing to do would be to promote Product A! It is the only one that generates the rate of gross profit per day required to generate a profit. In fact, product A generates Net Profit at a rate of $500 per day while products B and C both generate LOSSES at a rate of $500 per day.

Would it have been useful to have this information to begin with? Yes!

It’s your CFO’s fault for not including it, but she thinks in terms of reporting numbers. AND it’s your COO’s fault because he thinks in terms of how to produce at 100% regardless of the rate of profitability. As CEO, it’s your job to look at the business as a whole and to identify and to incorporate all of the necessary data into your decision-making.

Now answer this honestly … when you discuss relative profitability of your products/services do you discuss it as a RATE–specifically the rate at which your products or services generate Gross Profit (when COGS or COSS are defined as ONLY the costs that exit the business)?

I thought not. Like many others, you look at Gross Profit or Gross Margins–because you aren’t strategically linking your accounting and operations data.

So, who’s to blame? Remember the saying, “when you point a finger at someone, there are three pointing back toward you.”

If you answered this quiz, as most people do, with either Product B or C you should be VERY uneasy right about now because you are among the vast majority of business leaders who do not truly understand the relative profitability of their products or services.

Here is the good news: if you understand this simple yet fundamental concept, you can create an amazing competitive advantage.