The Financial Side of Product Management

Product managers need to establish a framework of financial plans,
budgets and controls related to their products, services, and customers to be able to make sound decisions. The starting point is a foundation of financial and managerial accounting to better understand the profit contribution of their offerings so that decisions on product rationalization,
pricing, and product-line management can be made. From a broader
financial perspective, product managers should understand key ratios and concepts drawn from an understanding of financial statements.

General Cost Classifications

In manufactured product environments, there are two major cost classifications, manufacturing and nonmanufacturing, each of which has sub classifications.

Manufacturing costs include all those related to the transformation of raw materials into final products, including direct materials, direct labor, and manufacturing overhead.

• Direct materials, such as wood in tables and steel in cars,
  become an integral part of the finished product and can
  be considered direct costs. Other materials, such as glue,
  may be more difficult to link to individual units of
  production and may be classified as indirect materials to
  be included in overhead.
• Direct labor includes the labor directly traceable to the
  creation of products. Research and development, support staff
  time, and other labor not directly related to manufacturing
  are included in indirect labor.
• Manufacturing overhead includes all costs of manufacturing,
  excluding the direct material and direct labor costs
  described above. Included in this category are items such
  as indirect material, indirect labor, heat, light, and depreciation.
  

Nonmanufacturing costs include the marketing, sales, administrative, and support costs unrelated to the production of products. These are typically included on the SG & A (selling, general, and administrative) expenses line of an income statement.

Historically, the nonmanufacturing costs have been less significant than the manufacturing costs for most products. However, the growth of services and the emergence of various technologies have reversed the relative weight of these costs in many companies.

• Marketing and selling costs include advertising, shipping,
  sales commission, and salaries.
• Administrative expenses include executive, organizational,
  and clerical salaries.

Both manufacturing and nonmanufacturing costs result from the
normal operation of a business. In addition, there may be other expenses, such as the purchase of an asset, that are charged to the income statement for the period, even though they are not operating expenses. These costs are presented in the simplified income statement on the next page. The cost of goods sold includes the direct material and labor as well as manufacturing overhead.

The data are frequently derived from standard costs and are a combination of fixed and variable expenses. (Standard costs are
predetermined cost amounts that represent what cost should be under the most efficient methods of operation; in other words, they are benchmarks for measuring performance.) Similarly, the overhead expenses (comprised of the nonmanufacturing or SG & A expenses) may be a combination of fixed and variable costs.
The income statement resulting from the above process of listing
costs provides a historical review of the results of operations. It does

not necessarily provide the information for planning and improving
the decision-making process of product management. To provide this type of information, it is necessary to distinguish between the variable and incremental costs associated with products to better understand their contributions to overhead and profit.

Concepts of Segmented Reporting Variable costs are those that vary in direct relation to the activity level.

If activity level doubles, variable costs double in total. This is true
because the cost per unit stays approximately constant over a relevant range of activity. Direct materials and direct labor are variable production costs, and sales commissions represent a variable sales expense.

In addition, there may be step-variable (similar to incremental or semi fixed ) costs. Setup time, seasonal labor, and similar activities related to the amount of business can be considered variable to that piece of business.

Fixed costs, on the other hand, do not change regardless of
changes in the level of activity. Since fixed costs remain constant in
total, the amount of cost per unit goes down as the number of units
increases. It is sometimes said that variable costs are the costs of doing business, whereas fixed costs are the costs of being in business.

Once costs have been separated into fixed and variable elements,
it is easier for product managers to determine the contribution of different products or customer segments. It is also easier for companies to evaluate the performance of several product managers. A comparison of a traditional income statement (using historical cost information) and a contribution income statement (separating fixed and variable costs) is shown in Figure 11.2.

Note that in Figure 11.2 the top line (sales revenue) and the bottom
line (net income) are the same using both approaches. However,
using the contribution margin approach it becomes clear that these
particular sales contribute $9,300 to fixed costs (prior to break-even) and profit (after break-even is achieved). (See Chapter 12 for a discussion of break-even analysis as it is applied to pricing decisions.) This concept of contribution reporting can be applied to business units, departments, product managers, product lines, customers, or similar units of analysis. When applied to these segments, direct costs and common costs must be understood.

Direct costs are those that can be identified directly with a particular
unit of analysis (i.e., product manager, product, customer, etc.) and that arise either because of the unit or because of the activity within it. Common costs are those that cannot be identified directly with any particular unit, but rather are identified in common with all units. The common costs (most likely fixed costs) cannot be allocated except through arbitrary means.

example, company revenues are $900,000, of which $500,000 come from Product Manager 1 and $400,000 come from Product Manager 2. They contribute $80,000 and $170,000, respectively, with $160,000 in overhead not allocated to either. The $400,000 revenue of Product Manager 2 comes from a standard model ($150,000) and a custom model ($250,000) contributing $70,000 and $140,000, respectively.

Product Manager 2 has $40,000 of fixed expenses not related
directly to either product. The custom product receives $180,000 from contractors and $70,000 from residential customers to generate its $250,000 in revenue. The segment contributions are shown without an arbitrary allocation of the $10,000 of fixed costs for the custom model which aren’t directly related to either customer group.

Cost Drivers

Before a product manager can price a product or evaluate a product
line, he or she must understand what the cost drivers are for the various products and customers. Some customers require additional expediting charges, others require special shipping and handling, while others expect free services. Each of these costs should be allocated to the particular product or customer to determine the true financial contribution.

Financial Statement Analysis

As suggested earlier, financial statements are historical documents indicating what happened during a particular period of time. This perspective helps a product manager judge past performance through the use of ratios. In addition, by comparing changes in the statements over time, it is possible to identify performance trends and use the information for subsequent decisions.

Investment Decisions

Directly or indirectly, product mangers may be involved in capital budgeting decisions in the preparation of investment proposals for new products, new markets, or new business ventures. The most common methods of evaluating different proposals are average rate of return, payback period, present value, and internal rate of return.
The average rate of return is the ratio of the average annual profits
to the investment in the project. Using this method, the product
manager prepares a forecast of the improvement in profit over a number of years from a given investment. The total profit is divided by the number of years to give an average annual profit, and this is then expressed either as a percentage of the original investment or as a percentage of the average investment per year. Assume the following stream of profits from, for example, a new product:

Year 1: $100,000
Year 2: $200,000
Year 3: $300,000 Average: $240,000
Year 4: $250,000
Year 5: $350,000
Total: $1,200,000

 

If the initial investment was $1 million, the average annual profit
would be the $240,000 as a percent of $1 million, or 24 percent. Alternatively, the $240,000 could be expressed as a percentage of the average investment for each of the five years. In either case, the rate would be compared to hurdles used by the company or to industry norms. The payback period is calculated by determining the length of time (number of years) it takes to recover an initial investment.

In the above example, the investment of $1 million is paid back during the fifth year. After four years, the cumulative profits are $850,000, with the remaining $150,000 being earned sometime during the final year. Here again, the payback as an absolute value is less important than looking at the relative values of different projects.

The present value (or net present value) refers to the value of future
cash inflows compared to the current outflow of the initial investment.

 

The internal rate of return is the interest rate that makes the present
value of all projected future cash flows equal to the initial outlay
for the investment. In other words, it is the rate that makes the net
present value (NPV) equal zero. The calculation is somewhat complex mathematically, and since it is a value that would be provided by your financial group, the definition should be sufficient for our purposes.