Once upon a time there was an entrepreneur who invented the world’s best black-ink pen. Customers loved them. Sales grew monthly. The profit margin grew from 5% to 10%.
In the second year the Sales Manager recommended offering customers a pen with blue-ink. The entrepreneur replied “It’s okay with me, as long as you can sell them.” Customers bought lots of pens. Sales revenue grew over the previous year by 15% but profit margin slipped from 10% to 9%.
In the third year the Sales Manager recommended adding pens with red-ink. Once again the entrepreneur replied “If you promise to sell lots of them, it’s okay with me.” Support staff asked and were approved for more people and budget to handle the complexity issues of having a three colors of ink. Sales revenue grew but profit margin slipped again from 9% to 7%.
Over the next two years ink colors grew to a total of ten. Customers seemed to like the variety of colors. Support staffs in Purchasing, Warehouse, Accounting, Quality Assurance and Manufacturing all added more employees to handle the increased workload and complexity of planning, making and selling ten colors of pens, e.g., 10 inks to purchase, 10 colors to separate in the warehouse, 10 quality specifications, frequent changeovers on the ink-filling production line. Sales revenues grew 10% per year but the company profit margin dropped to 5%.
The slippage in profit margin was unacceptable to the entrepreneur. He asked the Sales Manager “What price do we charge for each pen?”
“Each pen sells for $1.00.”
“How much does it cost to make pens?” asked the entrepreneur.
The Sales Manager shrugged her shoulders and replied, “I assume they all cost the same since they look the same.”
Was the Sales Manager correct?
No. Each color pen does NOT cost the same to make or sell. The majority of overhead cost that was added to the business over the five years had nothing to do with the black-ink pens that were the first and primary product of the business. The pens may look the same but they don’t cost the same to make.
Changeovers were not caused by black pens. Changeover time and cost in the factory were caused by blue, red and all the other color inks, not black.
Salaries and office overhead costs related to staff added in Purchasing, Warehouse, Accounting, and Quality Assurance to deal with the addition of ink colors had nothing to do with black-ink pens and everything to do with blue, red and purple pens.
Black pens were over-costed … and likely overpriced. All the other color pens were under-costed and underpriced. The profit margin on black pens was actually 15%. Red, purple and all the other colors made a mere 1% profit.
Does your company have a black pen?
If you’re not sure, you probably do.
A good cost accountant using the Activity Based Costing (ABC) method can assess your situation and prescribe options to improve your Income Statement. If you don’t know a cost accountant, e-mail TomPryor@icms.net and I’ll offer options.