Profit as a percentage of sales is an almost universal measure of product or customer value. When someone says, “We earn a ten percent profit on our sale of Product X,” it means that every time they sell $1.00 of Product X, they pocket a $.10 profit. It is taken for granted that the ten percent profit realized on Product X makes it more valuable to an organization than the eight percent profit realized on Product Y. Unfortunately, this common measurement—profit as a percentage of sales—is about as good a tool for measuring the value of a product or customer to an organization as a thermometer for determining a wind-chill index. It only provides one-half of the information needed to make an accurate measurement of value.
The purpose of a for-profit company is not to generate the highest possible profit as a percentage of sales. Its purpose is to provide the best possible return on the owner’s investment. Calculating profit as a percentage of sales requires two numbers: profit and sales. Calculating return on investment also requires two numbers: profit and investment. It is impossible to determine the contribution of an individual product or customer to the attainment of the company’s overall financial objective without attributing, either directly or indirectly, both profit and investment to that product or customer.
Consider the company whose product profitability information is shown in Exhibit 1. The company has two products: Product A and Product B. Both products generate $5 million in sales, and the total cost of both products is $4.5 million. As a consequence, the profit as a percentage of sales for both Product A and Product B is ten percent.
Is the value—and therefore the desirability—of these two products really equal? Consider this, as measured by activity cost (the cost of operating the business: salaries, wages, benefits, taxes, depreciation, utilities, consumables, etc.) twice as much cost is required to generate Product A’s profit than is required to generate the equivalent profit selling Product B ($3 million vs. $1.5 million). Since twice as much cost is required, it could be inferred that the resources required to produce $1 of Product A sales are twice those required for $1 of Product B sales. In effect, the company can produce $2 worth of Product B and a $.20 profit using the same resources it takes to produce $1 of Product A and a $.10 profit.