Every business owner must manage two scare resources: money and time. At first glance, investing in marketing and sales efforts to increase revenue should always pay off. However, if you don’t look carefully at your product sales mix, you won’t maximize company profit. It’s not just about total sales. You also need to consider each product you sell and the profit it generates. Use these tips to increase profits using sales mix.
A simple example
Assume that you manage a sporting goods store. You sell a line of metal bats for $50 each and earn a $10 profit. The store also sells baseball gloves. The gloves have a price of $100 and earn a $15 profit.
Sales mix considers the dollar amount of each product you sell, and the profit margin on each product. Profit margin is defined as (Profit per unit) / (Sale price per unit). Using profit margin allows you to make an “apples-to-apples” comparison between your products.
Profit margin states the percentage profit earned on each dollar of sales. The formula removes the sale price of each item- each sale price may be different. Instead, profit margin simply looks at the amount of profit per dollar sold.
Your sporting goods sales mix
The profit margin for the bats is ($10 / $50), or 20%. Your baseball gloves have a profit margin of ($15 / $100), or 15%. Even though the sale price of the bats is half of the baseball gloves, you make 20 cents per dollar of sales on the bats. Your glove sales only earn 15 cents per dollar sold.
Ok, so how can you use this information? One goal should be to shift more of your total sales to the more profitable product. In this case, you should sell more bats and fewer gloves.
The spreadsheet provides a more detailed sales mix analysis. Hillside Jeans sells two styles of jeans. Last month, Hillside sold 100 units of the Straight Leg jeans and 150 pair of the Confortable Jeans. Based on the total of 250 jeans, Straight Leg represented 40% of jeans sales (100 units/ 250 total units). Confortable Jeans represented 60% of total sales.
The next part of the spreadsheet explains the profit for each style of jeans. For each style of jeans, you’ll notice a per unit calculation on the left and a total dollar amount. Let’s go over the per unit amounts for Straight Leg jeans. Here’s the first part of that formula:
$50 revenue – $25 variable costs = $25 contribution margin
Contribution margin covers each product’s share of fixed costs. Whatever remains after paying fixed costs equals your profit.
Contribution margin is useful when considering sales mix. That’s because fixed costs are harder to assign to a particular product. Since the costs are harder to assign, you may not assign them correctly.
Here’s a fixed cost example. You pay a fixed salary to a supervisor to manage your production. You need to allocate the cost of the supervisor to each of your products.
You could allocate the supervisor’s cost based on the number of units produced, for example. If Straight Leg jeans represented 40% of the production, the product line could be assigned 40% of the fixed cost. Companies also allocate fixed costs based on labor hours worked or machine hours used.
Whatever allocation method you use, your estimates might be incorrect. Instead of 40%, maybe the supervisor spends 55% of this time of the Straight Leg jean production process. The point here is that your might allocate fixed costs incorrectly.
Contribution margin and sales mix
Given the problems with allocating fixed cost, many firms use contribution margin per unit to make decisions about sales mix. The view here is that contribution margin does not include fixed costs, which cannot be allocated easily.
Here’s another way of thinking about it. Eventually, all fixed costs have to get paid. Some products may have too much fixed costs allocated, others too little allocated. Let’s remove the uncertainty and look at profit before fixed costs. That means contribution margin.
The higher the contribution margin per unit, the more profitable it is to sell that specific product. The spreadsheet indicates that Straight Leg has the higher contribution margin per unit ($25 vs. $20). Straight Leg is more profitable, using contribution margin as your yardstick.
Covering fixed costs in total dollars
You’ll notice that both product lines produce operating income of $10 per unit. While Straight Leg has the higher contribution margin per unit, it also gets a higher allocation of fixed costs. Again, that fixed cost allocation may not be completely accurate.
A better way to view fixed costs is to look at the total dollars. If you look at the far right hand column on the spreadsheet, you’ll see that Hillside must pay $3,000 in fixed costs. Those costs have to be covered, regardless of how they are allocated between products.
This is why using contribution margin may be more accurate than profit margin.
So, the game with sales mix is to sell more of the products that generate a higher contribution margin per unit. You need a tool to judge how well your sales mix changes have improved your results. One tool you can use is weighted average contribution margin.
The bottom of the spreadsheet displays the weighted average calculation. The numerator multiplies contribution margin per unit by the number of units sold. That calculation is done for each product, and the results are added together. In this case, the total is $5,500.
The $5,500 in sales is divided by 250 units sold. ($5,500) / (250 units) is a weighted average contribution margin of $22 per unit. The goal is to sell more goods that generate a higher contribution margin per unit. If you do, your weighted average will increase. That means that you sales mix is headed in the right direction.
Applying these concepts
These same concepts can be used if you sell dozens or even hundreds of products. Compute the contribution margin per unit to determine which products are more profitable. Shift your sales efforts to sell more products with the higher contribution margin. Use the weighted average contribution margin to see if you’re improving your results.
Sales mix analysis will help you focus your sales and marketing efforts and increase your profitability.