The four biggest levers impacting profits for a product-based business
One of the most common topics we’re asked about is around profitability for product-based business. It can feel overwhelming trying to understand what a realistic profit is, and what the biggest drivers for this can be. Unlike service business where there is a more direct correlation between effort and reward, when it comes to products there are a whole lot more to consider and labour is often NOT a direct cost that is factored in. Profit in a product-based business is generally a function of both scale and the likely exit plan - whether that’s selling the entire business, getting outside investors to buy a share of the business or reinvesting profit into the business for an extended time (often 5 - 10 years plus) to achieve real scale in revenue.
Product based business have the biggest potential long-term profitability due to the nature of being able to sell the entire business and the goodwill that goes with it, which can be substantial if you’ve built your business well!
So, how do you determine what the potential profit of your business could be and what are the biggest levers to lift profitability?
The simple rule-of-thumb guide to working out potential profit is:
SALES VOLUME x (SELL PRICE - COST OF GOODS - SALES & MARKETING COSTS) = PROFIT
For the purposes of this article, I’m going to use a SUPER simplistic set of assumptions to demonstrate the impact of different levers on profit.
Your sell price to Retailers is $10.00/ unit
Cost of goods = $5.00/ unit
Sales & Marketing costs = $1.00/ unit (20% of COGS/ 10% of Sell price)
Target profit per year = $50,000
Often the biggest unknown in this equation is volume, so simply invert the formula so you divide target profit ($50,000) by the net margin (Sell price - Cost of Goods - Sales & marketing costs)
So in order to hit the target above with a profit of $50k, then the formula is
>> $50,000 / ($10-$5-$1) = 12,500 units (which is $125,000 revenue)
This means selling just over 1,000 units a month, with a revenue of ~$10,000/ month, at a net margin of $4.00 per unit in order to achieve $50,000 profit to cover all your time, labour and overheads for the business. Now this assumes that you can keep your TOTAL sales and marketing costs to $12,500 a year (12,500 units x $1/ unit) and doesn’t include all the other costs to run your business like insurance, overheads, and your time.
Summary: To achieve $50,000 profit, you need revenue of $125,000/ year using the simple costs noted above.
To understand how to drive profit, you need to look at each of the main levers and work through how you can influence each area. This can be calculated on a simple spreadsheet by typing in each of the variables, and having a play around to understand which you can influence the most in the short-term (generally volume, price and sales & marketing costs) and long term (cost of goods).
1: SALES VOLUME (UNITS)
The volume you can sell is one of the biggest factors in determining the amount of total profit you’ll likely be able to get from a business in a year. If you’re just starting out and bootstrapping, it likely that you’re either making it yourself or buying wholesale at the smallest volumes. This means that your volume potential is directly linked to how much you have to invest in stock - either buying it wholesale or in purchasing ingredients & packaging.
To understand what the potential profit could be it critical to understand three main factors when it comes to volume:
How many you can SELL in a year
Making or buying products takes a lot of time and investment
SELLING products to consumers or Retailers also takes a lot of time, and investment… just because you make it, doesn’t mean there automatically is a willing buyer to take all your products. Sales takes time to build a customer base, go and visit retailers (generally multiple times, plus emails, calls and general follow up) and rapidly scaling volume comes at a cost of capital. One useful calculation to look at is how many Retailers / customers can you service in a day/ week/ month, and what would it take in both time and cost to achieve this.
How many can you PRODUCE in a year
If you’re making your products by hand yourself - think about how many you can realistically make in a day or week. Is it labour intensive or something that can be mass produced relatively easily? Do you have the capacity both physically (storage space and with labour) to make the volumes that you need, or do you need to get extra help to make the products? Rather than investing in your own manufacturing, look for contract manufacturers that help business to scale (The Food Bowl is a great one for food and beverage producers, and there are a whole lot of small skincare contract manufacterers in NZ as well. Remember, your price doesn’t necessarily reflect the number of hours that it takes to produce each product.
What are your sales channels
Your sales channels are the different ways that consumers are going to buy from you. Having a clear sales channel plan, and strategy for how you are going to grow your volumes is a great way of calculating the volumes and level of investment to grow your business.
Often business start small with local markets, or through their own brand websites, however in order to achieve scale of volume you will need to think broader about ways to sell your products. These are a great way to test and refine your product, get super-clear on who your target market are & what they’re looking for as well as providing initial sales momentum so you know how to market & promote your products as you scale. Volumes are generally low and won’t provide significant salary-level income, however that doesn’t mean they aren’t worth doing.
Supermarkets and large retail chains are large volume due to the number of stores that they have and the volume of customers that visit each week. Although your sales per store may be as low as 1 unit per store per week (which is not uncommon in premium categories in grocery), the sheer total number of stores means you can sell through good volume nationwide.
Distributors and/or wholesalers can give you reach into new geographies and exposure to different groups of customers eg Foodservice or B2B, and help with volume growth. Remember to account for their margins in your pricing and profit model so you don’t get an unexpected hit.
REMEMBER: If you start selling through a Distributor then you MUST account for their margin as well in the value-chain. This could be 10-15% of your list price to Retailers and its best-practice to factor this into your pricing model BEFORE you start your business or you could find a real margin squeeze and profit hit, once you have to start paying this. They can be a great way to drive volume and worth the cost to get you to scale to achieve your profit goals - especially if its about reaching new geographies or into specialist sales channels.
The relationship between unit sales and profit, assuming all other financials stay the same - is a direct one. If you increase volume by 10% (so going from 12,500 units to 13,750 units/ year >> 12,500 x 1.1 = 13,750), then your profit increase is >> 13,750 x ($10-$5-$1) = $55,000.
There is a direct correlation of volume to profit - 10% increase in volume = 10% increase in profit.
2: SELL PRICE (TO CONSUMERS OR RETAILERS)
Setting your prices by working ‘top down’ before you launch is one of the most important things you can do to set your business off on a profitable path. This means doing a whole lot of analysis around customer and retailer expectations, competitors and more (there’s a separate blog post coming on this). Identifying the best ‘recommended retail price’ - RRP - as well as the ideal retailer margin - is an art as much as it is a science. Its about truly understanding the value you give your target consumers, the relative price position for your brand in the category and vs competitors, and what margin you can deliver retailers while still having enough to cover your own costs and margin expectations.
The same philosophy applies whether you’re selling direct to consumers through your website, or if you’re selling on retail shelves. Sure there is more margin % if you sell direct, however there are generally also significantly MORE sales and marketing costs to get consumer traffic so your net margin may be the same.
One thing holds true is that price is the biggest lever to profit. If you can lift your price by 10%, and hold all other costs equal, then that has an exponential impact to your bottom line. In the example above, if the sell price is $11.00 (instead of $10), volume is still 12,500 units and total costs are still $4 >> then profit is 12,500 x ($11-$5-$1) = $62.500 - that’s a 25% increase in profit for a 10% increase in sell price!
3: COST OF GOODS
Your cost of goods is a function of how much you put into your product…. do you have a lot of unique (and likely expensive) ingredients? Is the
Your COGS should include at a minimum:
The physical cost of the item
Packaging to send it out (if Direct to consumer, the shipper if you’re sending to Retailers)
Inbound logistics costs (how much it costs to get to your house or warehouse)
Third party logistics costs for picking and packing (if you can’t charge for this in shipping)
If you want to reduce your cost of goods then consider:
Do your target consumers really value all the ingredients and attributes of your product? For example. do they need every ingredient to be fair trade certified vegan organic? Or is this not something they are willing to pay for and don’t want or need.
How are you packaging your product - both the individual unit and the shipper/ final product? While it can be super exciting to create an amazingly custom box for your product to arrive in via courier, if your consumer isn’t willing to pay for the cost of this as part of the sell price (you definitely need to factor this in COGS) and/or its adding complexity and waste, then consider what the best and most effective is cost-wise to achieve your brand position. You can funk up some standard boxes with labels, or tissue paper and save yourself $ along the way.
Are you producing at the bare minimum order quantity - or can you lift sales volume to achieve higher production volumes? It can feel a bit ‘chicken and egg’ as you need the sales to cover the cost of goods without having lots of dated product AND you also need the product in order to sell higher volume in order to reduce your cost of goods.
The key here is to think about how much you can afford to invest in product and reducing your cost of goods through improving production volumes AND whether you’re able to drive enough sales to clear through the product in a reasonable time.
Investing in bigger volumes is often a smart move once you’ve got through the early stages of business and learnt what customers and Retailer do and don’t value in your products. This means that when you DO decide to invest in higher volumes (and reduce your COGS), then you’re much more confident that you’re giving people what they want and are willing to pay for.
In the example, if you reduce your COGS by 10% from $5 to $4.50 ($5 x 0.9), then the impact on your profit is:
12,500 x ($10-$4.50 - $1.00) = $56,250 - that’s a 12.5% increase in profit by reducing your COGS by 10%
4: SALES & MARKETING COSTS
In order to achieve your sales volume targets, you'll need to invest in both sales AND marketing to get consumers to both be aware of your product and convert that awareness into sales. When starting out via markets, this can involve not only your time but also the marketing collateral for your stand, vendor fees and the cost of any unsold stock (which can be considerable if your products are perishable). There is the uncertainty of how many people will attend the event, and the downside of running out of stock (and potential sales) if you oversell early.
Its no secret that setting up a brand website is relatively low cost, but the effort and investment to drive traffic to your website can be complex and increasingly costly. Traffic volume is the biggest driver here. If you sell direct via your brand website with a 5% conversion rate, then you would need web traffic of 20,000/ week to achieve 1,000 units sold (the formula is 1,000 units / 0.05 conversion rate). In the example above, the costs allocated to this are only $1.00 total for every converted sale and I’ve no doubt that in some categories it can be more than this!
Marketing costs can get out of hand VERY quickly, especially if you don’t have a target % of sales price or revenue that you’re using as a guide. You may find that your marketing costs can be higher than COGS meaning you don’t even break even and this can be a very expensive lesson to learn.
One tip is to constantly look at the return on investment for your marketing activity and be clear whether its short-term sales driver or a long term brand & awareness builder. There is real danger in using price promotions to drive sales as the ROI can look ok, but it eventually erodes your margin as more and more consumers come to expect it as ‘normal’.
If your costs are too high, and they’re not driving a result, then the impact on profit can be significant. If you lift your Sales & marketing costs from 10% to 20% of sales, then the impact on your profit is:
12,500 x ($10-$5-$2) = $37,500 - that’s a 25% reduction in profit by increasing your sales & marketing costs by 10% of RRP (or 50% increase in total cost).
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IN SUMMARY one of the biggest pieces of advice I can give to anyone is to do your PLANNING upfront - that means setting up some simple spreadsheets to map out all your assumptions under the key buckets above, and knowing what you need to do to deliver those. If you’re already underway with your business and struggling to achieve your goals, then doing a deep dive into your numbers, and sitting down with your accountant to understand your cost structure & profit is a great idea.
Check out our resources page for a DIY margin calculator, detailed guide to sales & marketing costs when working with Retailers and the option of a 1:1 session with me to work through your own profit margin & look at how you can improve.
