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Consider All Your Costs Before Adding New Products and Services

Jan 8, 2008
A small business leader asked me how he could improve his profits. The business had been established for 50 years and provided more than 4,000 items. The warehouses were bulging with obsolete inventory. What should he do?

I did a profit analysis by item and customer and determined that the company was losing money on 99 percent of the items and 99 percent of the customers.
Drop those items after the old inventory was sold, and the business could also add two million dollars in cash.

The leader could then operate the business with three people and make over a million dollars a year in profit. He would only need to work an hour a day to do so. He liked that idea.

Most businesses think about selling more items or services as an opportunity. Why not?

Done properly, selling or providing more of what you already offer can be a big help in creating efficiencies. But sometimes you are serving virtually all of someone's needs for those items.

The application to a for-profit organization is obvious. What else can you profitably sell or provide at a fair price with desirable qualities and service that the customers you already have want to buy? The advent of the Internet makes this evaluation much more potentially rewarding because postal, air freight, and electronic delivery choices enable you to serve most of the world with your added offerings.

This for-profit challenge requires considering the potential volume and the effects on overhead costs and profit contribution margins. Example 1 shows the kind of effect that a positive change in volume can make by adding volume through more profitable items that do not increase overhead costs very much.

Example 1: Adding More Profitable Items to Expand Revenues Without Increasing Overhead Costs as Rapidly Further Speeds Profit Growth

This example shows the profit multiplying potential of increasing profit contribution margins from 30 percent to 40 percent while decreasing corporate overhead costs from 20 percent to 3 percent of revenues. The result is a 7,700 percent profit solution. If revenues could be grown even more, a 40,000% improvement (a 2,000 percent squared improvement) could result.

Annual Pro Forma Financials Before Volume Expands

Revenues $1,000,000

Cost of providing offerings $ 700,000

Profit contribution $ 300,000

Corporate overhead cost $200,000

Pretax profit $100,000

20 Times Volume Increase with Higher Profit Contribution Products and Limited Additional Overhead Expenses

Revenues $21,000,000

Cost of providing offerings $ 12,600,000

Profit contribution $ 8,400,000

Corporate overhead cost $ 600,000

Pretax profit $ 7,800,000

The challenge in making such a change is to focus on both higher profit contribution offerings and keeping overhead and operating costs low. The mistake that many make is to only look at the contribution percentage. When that happens, the gains in profitability may be eaten up by new costs to deliver the added offerings that more than offset the profit contribution of those offerings. Exhibit 2 demonstrates that point.

Example 2: Adding More Profitable Items to Expand Revenues Hurts Profits When Overhead and Waste Costs Grow Too Rapidly

The potential profit gains from higher profit contribution percentages (going from 30 percent to 40 percent in this example) can be more than offset if waste and overhead costs grow too rapidly in providing required items. Perishable, high-tech, and fashion items often have this problem as time causes value to decline, resulting in waste or markdown charges. Higher profit contribution offerings often require more administration and service to support them.

Annual Pro Forma Financials Before Volume Expands

Revenues $1,000,000

Cost of providing offerings $ 700,000

Profit contribution $ 300,000

Corporate overhead cost $200,000

Pretax profit $100,000

20 Times Volume Increase with Higher Profit Contribution Items and Faster Growth in Overhead and Waste Expenses

Revenues $21,000,000

Cost of providing offerings $12,600,000

Profit contribution $8,400,000

Added waste and markdowns $3,150,000

Corporate overhead cost $5,200,000

Pretax profit $50,000

How can these mistakes be avoided? The best way is to start with small experiments where you can measure the increases in volume, profit contribution, and costs before committing to a major change in your business model.
About the Author
Donald Mitchell is an author of seven books including Adventures of an Optimist, The 2,000 Percent Squared Solution, The 2,000 Percent Solution, The 2,000 Percent Solution Workbook, The Irresistible Growth Enterprise, and The Ultimate Competitive Advantage. Read about creating breakthroughs through 2,000 percent solutions and receive tips by e-mail by registering for free at

http://www.2000percentsolution.com .
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