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How to calculate product mix impact on profitability?

Product mix impacts profitability

How does profitability change even if the revenue and cost stay stable? Product (or customer) mix might be the answer. In this post we will explain what product mix is and how to calculate its impact on the profitability.

Let’s start very simple. Imagine your business have two products – a simple one and a premium one:

 Basic ProductPremium Product
Cost$ 10$ 20
Average Selling Price$ 20$ 50
Gross Margin $$ 10$ 30
Gross Margin %50%%60

Let’s also assume that there is only 1 customer to remove the “customer mix impact” from the calculation (we will review this in another post).

Imagine first year you were selling a lot of basic products, and less premium products. But the second year there was a drop in basic products, and an increase in premium products that balanced the total revenue. I mean, a scenario like that:

Sales in UnitsYear 1Year 2
Basic Product10050
Premium Product4060
Total140 units110 units

Overall, our sales quantity went down from 140 units to 110 units. If we are covering manufacturing overheads, this might be a difficult situation. If these are traded items however, there would not be much change to the cost base.

But what’s the impact on the revenue and profitability? Let’s check:

  Year 1Year 2
    Line Total  Line Total
Product 1Sales$ 20 / unit100 units$ 2,000$ 20 / unit50 units$ 1,000
Product 2Sales$ 50 / unit40 units$ 2,000$ 50 / unit60 units$ 3,000
TotalSales  $ 4,000  $ 4,000
Product 1Cost$ 10 / unit100 units$ 1,000$ 10 / unit50 units$     500
Product 2Cost$ 20 / unit40 units$     800$ 20 / unit60 units$ 1,200
TotalCost  $ 1,800  $ 1,700
MarginTotal  $ 2,200  $ 2,300
MarginPerc.  55 %  57.5 %

As you see, the revenue stayed stable year-over-year at $ 4,000, but the profitability (gross margin) increased by $ 100, moving the gross margin percentage from 55 % to 57.5 %.

The reason behind is that the weight of the more profitable product in overall revenue shifted, resulting in a higher profitability.

In this theoretical example, we kept the following factors constant:

  1. The selling prices of the products did not change.
  2. The cost of the products did not change.
  3. The customer who buys the products did not change (what a customer pays for a product could be different than the other customer).

Therefore, the change in the profitability can be 100% attributable to the “change in product mix”.

Generic Product Mix versus Product Switch Between Substitutes

Imagine that your business is selling a basic main product, a premium main product, and accessories that are less profitable. The product shift (i.e. the volumes moving from one product to another) could be between the basic product to premium products, but also between main products and accessories.

In the overall financial term, the second scenario (transfer of volumes between any product family) is what product mix effect is. However, from a management perspective, this information may not give you much actionable insights.

If you were to know “the impact on profitability, originating from customer shifting from base main product to premium main product” you could take a more informed decision on the pricing or sourcing of these products. This impact would be the “product mix effect between substitutes”. This information would be more valuable, because it is actionable.

I personally used these calculations when we launch a new product as a successor to a legacy product, and monitor whether the profitability is under control during the transition.

How to calculate product mix in real-case scenaros

As explained above, we had kept the 3 factors constant to have a pure example on product mix. In real, at least the customer mix changes any moment, driving the calculation more complex. How would we calculate the product mix impact on profitability in this case?

Simple – we would calculate the product mix impact customer by customer, and add them up 🙂 Now this is easier said then done. However, if you are using advanced Excel, or better a more advanced query tool like SQL, you can develop (and even automatize) these calculations.

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