Managing product line profitability

For most companies, product line proliferation is a profit-drain, actually hurting profits.  Specifically, Pareto (and his 80 / 20 Rule) is alive and well in most companies.  Based on broad empirical observation, it is remarkably typical that 80% of a company's sales are generated by a relatively small portion of its products (20% or fewer).

On a profits basis, the effect (known as the whale curve) is even more pronounced: often 50% (or less) or all products generate more than 100% of a company's profits.  That is, the bottom half of all products in a line actually reduce lose money and reduce profits.

The obvious question is why don't more companies recognize these profit dynamics and pare back to a profitable core of products?

There are two basic explanations.  First, some products do provide substantial (and real) strategic benefits that compensate for their unfavorable economics.  In other words, profits earned by other products in the line, or at a later time, would be lost if the loss-producing product were dropped.  

More specifically, some product models have focused strategic importance:

Flagship models, often higher-end products, establish a company's image in the market despite relatively low sales.

Derivative models (slight variations of a core product) are often tailored to specific customer requirements.

Sheltered models (also slight variations of a core product) are unique products restricted to select accounts, intended to protect retail margins by frustrating a buyer's price comparison process.

Fighter models are typically priced aggressively, sometimes offered at a slight loss, but produced in limited quantities to contain financial downsides and protect core models.

A second explanation for losing products in a line is that traditional accounting systems and statistical averages obscure the real economics, in effect, hiding both costs and profits.  In other words, managers aren't aware of the profit implications.

More specifically, most businesses (especially those with a large services component) incur substantial indirect costs (e.g. overhead, support, supervision).  Most financial accounting systems assign direct costs (like direct labor and material) back to individual products with a relatively high degree of precision, but allocate indirect costs proportionately (based on sales or some other volumetric measure) across customers and products.  So, products that actually generate proportionally more indirect costs (e.g. low volume or specialty products) are, in effect, subsidized by those products that generate proportionally less indirect costs (e.g. high volume, standard products).  Profit is overstated for some products, and understated for others.

Activity Based Costing (ABC/ABM) is a methodology for reframing traditional financial accounting data to more precisely measure product level profitability.