Maximizing Profitability: Understanding Product Costs for Success
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Chapter 1: The Importance of Profitability
In today’s business landscape, understanding product costs is crucial for ensuring profitability. Every product is designed to provide value, for which customers are willing to pay. Essentially, the primary goal of any business is to generate revenue. When a company operates with a single or a limited number of products, the alignment between the company's vision and the product strategy is straightforward. It becomes relatively easy to allocate costs and investments to specific products, leading to clear profit calculations where the product's profit mirrors the company's overall profit.
However, as companies expand their product lines, onboard more customers, and hire additional teams, the dynamics shift significantly. This growth introduces competition for resources among product teams, as the organization strives for sustainable growth and retention.
To illustrate the challenge of allocating resources effectively, consider a hypothetical company that purchases raw materials, manufactures widgets, and sells them.
Section 1.1: A Simple Example of Profit Allocation
In this scenario, John is responsible for procuring raw materials at $100, while Jane manufactures and sells the widgets for $200. Initially, the company enjoys a profit of $100.
When Melinda, an investor, acquires the company, she notices that profits rise to $150. Delighted, she contemplates rewarding John and Jane but is uncertain who deserves credit for the increase. A closer look at the financials reveals that raw material costs have jumped to $140, while the selling price escalated to $290, resulting in a new profit of $150.
Melinda is eager to incentivize her managers, but her initial inclination to reward Jane complicates matters.
Subsection 1.1.1: Uncovering the Real Contributors
Upon discussing with John, Melinda learns that inflation has inflated raw material prices to $200. However, due to his negotiation skills, John managed to keep costs at $140. Surprised, Melinda then speaks with Jane, who argues that her pricing reflects market inflation. Jane also points out that competitors have raised their prices even higher than hers.
Faced with conflicting claims, Melinda struggles to determine the responsible party and how to incentivize them appropriately. This situation illustrates the complexities that arise as companies scale, where multiple products and functions create a tangled web of accountability.
Chapter 2: The Role of Treasury in Conflict Resolution
To manage the friction between John and Jane, companies often establish a Treasury function. This department serves as an impartial entity that evaluates internal pricing and performance metrics.
In our example, Melinda appoints a CFO who sets up the Treasury function. Now, John sells raw materials to Treasury, which in turn sells to Jane. This separation allows for fairer pricing and performance assessments. If market prices rise to $200, Treasury compensates John at market value, while Jane pays the same amount for her materials.
This structure clarifies profitability: John now earns $60 while Jane makes $90, totaling $150, consistent with previous profits.
Section 2.1: Understanding Transfer Pricing
The prices set by Treasury for these transactions are referred to as "Transfer Pricing." This accounting practice determines the cost of goods and services exchanged between different divisions of a company.
Transfer pricing is crucial, as it influences how profits are allocated. In our example, without Treasury, John’s contributions might have been misinterpreted as negative, while Jane’s profits would appear inflated.
Section 2.2: The Impact of Financial Strategy on Product Management
Every product incurs costs related to manufacturing, marketing, and sales. As a product manager, it’s essential to view your product as a standalone business with its own Profit & Loss (P&L) statement.
By engaging with finance teams, you can uncover opportunities to optimize costs across departments. This collaboration should be constructive, focusing on strengthening relationships rather than assigning blame.
Example: A Case Study in eLearning
Consider a product manager at an eLearning company with two offerings: a subscription service generating $150k annually and a one-time PDF textbook sale bringing in $100k. Marketing efforts costing $200k attract customers, but most end up purchasing textbooks instead of subscriptions.
When bonuses are calculated, the subscription product shows a loss of $50k, while the textbook product appears profitable. This scenario emphasizes the importance of understanding how marketing costs are allocated to your product, as it can significantly affect your perceived performance.
As a product manager, it’s vital to engage regularly with financial partners, particularly during planning sessions, to align on assumptions that impact your budget and ultimately, your success.
Author
Yaniv Nathan is a transformative product leader with experience launching multiple product lines and features. He specializes in enhancing digital processes and product management practices.
Twitter: @PM_isBusiness | LinkedIn: Yaniv Nathan | Follow me Yaniv Nathan