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The Fallacy of Profit as a Percentage of Sales: Part I

If the $4.5 million of activity costs represents the company’s capacity, it could generate $15 million in sales and $1.5 million in profit if all of its products were like Product B (See Exhibit 2.), but could only generate $7.5 million in sales and $750,000 in profit it they were all like Product A. (See Exhibit 3.) The existing capacity is only capable of generating half of its potential profit with items like Product A. Does this sound like Products A and B are of equal value in helping the company reach its financial objectives?

Hicks-March-14-Exhibit-2

As a first step in evaluating an individual product’s or customer’s value to a company, it might be better to measure profit as a percentage of the product’s or customer’s activity costs as an indirect, or surrogate, measure of investment. As shown in Exhibit 4 on page 46, Product B’s profit as a percentage of activity cost is twice that of Product A, indicating that it is twice as valuable—an evaluation supported by the “all Product B vs. all Product A” comparisons in Exhibits 2 and 3. Although by no means a perfect measure, profit as a percentage of activity cost is certainly a much more representative measure of the two products’ value to the company than the traditional measure of profit as a percentage of sales. Making this simple change alone will improve a company’s ability to pick and choose among the business opportunities available in the marketplace.Hicks-March-14-Exhibit-3

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