I have already discussed not so long a go about a great technique to leverage a category profitability by analyzing the Cost of Goods Sold, I wanted to discuss another key concept on how you should analyse profitability in retail nowadays. Indeed, gross margin is probably the most common KPI of profitability used in retailing, but it does not give you the whole picture.
In the chart you will find 5 different products, with different features. Depending on the KPIs you will look at, you will have a different prospective of what the performance of the products are.
If you look at Item A, it is the Item with the higher % of gross margin, which you may think is cool. But when you take into account all the direct product costs (DPC), which includes supply chain, wages, among others, you find out that you are loosing money on it.
Same thing about with Item E: You sell it the most, and despite a low % of mergin, it is the product that provides you the most gross margin at the end of the week (isn't it the concept of FMCG?). But at the end of the day, the resources required to retail the products are so big that the direct profit is negative.
In this example, it is the product C that is the most efficient and profitable. It doesn't have the best sales, it doesn't have the best % of gross margin, neither is it the most expensive, but the way its cost of goods sold is designed and how it performs makes it by such an analyzis the perfect deal.
The Direct Product Profitability modell allows you to make such an analysis. Its uses is common in companies like Walmart.
I believe that Direct Product Profitability is obviously by far the best way to analyze one product performance. Obviously, there may be other variables that are not taken into account, as the modell is more used for a purchasing strategy than an actual category management strategy. I believe that you should take into account the penetration rate of the product, or its loyalty rate, in order to understand how strategical the product maybe in your product range.
Here are The Seven Step DPP process
The DPP model is capable of calculating net profitability of individual items of fast moving consumer goods. Working with the DPP model is a seven-step process:
- DPP model fine tuning: the classical DPP model is adapted to specific product characteristics of your industry
- Input of process characteristics: process characteristics of the logistics chain are entered as activity drivers in the DPP model (examples: delivery frequency, productivity ratios)
- Input of general ledger resource costs: resource costs of the central depot, transportation and the store (examples: transportation cost per km, costs per working hour)
- Calculation of activity costs: activity costs are calculated in the DPP model
- Input of product characteristics: all characteristics of individual products are entered as cost drivers
- Calculation of direct product costs: activity costs are allocated to products
- Calculation and presentation of direct product profitability ratios
