Many companies grow sales year after year, and yet profit doesn’t grow at the same pace, or even falls. The explanation is almost never in the total but in the detail: some products and customers generate most of the profit, while others, even if they look good in sales, consume more resources than they contribute.
The problem is that traditional accounting rarely shows that difference. The income statement tells you how much the company earned, but not which products, customers, or channels made money and which lost it. That’s what a profitability analysis is for. In this article we share the signs that you need one and how to do it.
What is a profitability analysis?
A profitability analysis measures how much each product, product line, customer, channel, or region really contributes after considering not only the cost of goods sold but also the costs of selling, delivering, and serving it.
The key is that second part. Two customers can buy the same product at the same price and leave very different margins: one buys in large orders, pays on time, and needs almost no attention; the other places small, urgent orders, asks for special terms, returns goods, and pays at 90 days.
7 signs you need a profitability analysis
1. Your sales are growing, but your profit isn’t
If you sell more every year but net profit stays flat or drops, growth is likely coming from low-profit products or customers, or the costs of serving them are rising faster than sales.
2. You set prices with a blanket markup over cost
If you apply the same markup percentage over production or purchase cost to every product, you’re ignoring that each one consumes resources differently. Some end up underpriced and others overpriced relative to the market.
3. You allocate overhead “pro rata” to sales
Allocating administrative, logistics, or sales expenses in proportion to each product’s or customer’s sales is simple, but it usually penalizes the easy-to-serve ones and subsidizes the complex ones.
4. You have “big” customers who demand a lot
Special discounts, extended credit, split deliveries, dedicated staff, frequent returns. A customer can account for a large share of your sales and, at the same time, a very small share of your profit, or even a loss.
5. Your catalog keeps growing without review
Every new product adds inventory, planning, line changeover, catalog, and administrative costs. If you never discontinue products, a long tail of items is probably subtracting rather than adding.
6. Salespeople are measured only on volume
If commissions depend solely on sales, the sales team has an incentive to sell what’s easiest, not what’s best for the company: discounts, special terms, or low-margin products.
7. Nobody in the company can say, with data, which customer is most profitable
If the answer to “Who is your most profitable customer?” is based on perception or sales volume, you don’t have the information you need to decide on pricing, discounts, investments, or which customers to prioritize.
How to do a profitability analysis step by step
1. Define what you want to analyze
Start with the dimension where you suspect the problem lies: products, customers, channels, branches, or regions. Ideally you’ll combine them (for example, profitability by customer and product), but it’s best to start with one.
2. Calculate the contribution margin
The first level of analysis is the contribution margin: selling price minus the variable costs directly associated with it (raw materials, direct labor, commissions, freight, packaging). It shows how much each product or customer contributes to covering fixed costs and generating profit.
3. Assign overhead based on how it’s consumed
This is the difference between a superficial analysis and a useful one. Instead of spreading overhead in proportion to sales, assign it based on the activities each product or customer actually consumes: number of orders, deliveries, visits, line changeovers, support hours, returns, days of credit.
This approach is known as activity-based costing (ABC). Robert S. Kaplan and Steven R. Anderson proposed in Harvard Business Review a simplified, time-driven version based on how long each activity takes, which makes it much more practical to maintain.
4. Build your profitability map
Rank your products or customers from most to least profitable and chart cumulative profit. It’s very common to find a pattern like this:
| Group | % of customers | % of sales | % of profit |
|---|---|---|---|
| Highly profitable | 20% | 45% | 120% |
| Moderately profitable | 50% | 40% | 10% |
| Unprofitable | 30% | 15% | –30% |
Illustrative figures.
In other words, a small group generates more profit than the company earns in total, and another group “gives back” part of that profit. This shape is known as the “whale curve.”
5. Make decisions by segment
With a clear map, the nature of your decisions changes:
- Highly profitable customers and products: protect them, prioritize their service, and look to grow with them.
- Moderately profitable: review pricing, terms, and cost-to-serve to improve them.
- Unprofitable: renegotiate terms (minimum order, credit, deliveries), adjust prices, change the service channel or, as a last resort, stop selling to them.
6. Build profitability into management
The analysis loses value if it’s done only once. Include it in monthly or quarterly reviews, pricing and discount policies, sales team incentives, and the company’s strategic plan.
Common mistakes
- Stopping at gross margin. Ignoring selling, logistics, service, and credit costs leads to the wrong conclusions.
- Seeking absolute precision. A reasonably accurate analysis that gets used is worth more than a perfect one that’s never finished.
- Cutting products or customers without understanding the effect on fixed costs. Some costs don’t disappear when you stop selling, and some products “pull” the sale of others.
- Not involving sales and operations. Without their input, activity data will be incomplete and decisions hard to implement.
Frequently asked questions about profitability analysis
What information do I need for a profitability analysis?
Sales by product and customer, production or purchase costs, operating expenses, and activity data (orders, deliveries, returns, visits, days of credit). Much of it is usually in your ERP or accounting system; what’s missing can usually be estimated through sampling.
How often should it be done?
An in-depth analysis once a year is good practice, with quarterly tracking of the main indicators. It’s also worth repeating before major pricing, investment, or portfolio decisions, and it’s a key part of due diligence before buying or investing in a company.
Does this apply to service companies?
Yes. In service companies, the main cost is usually people’s time, so measuring how much time each customer or project consumes is even more revealing.
Should I stop selling to unprofitable customers?
Not necessarily. First, try to make them profitable: adjust prices, set minimum orders, change credit terms, or serve them through a more efficient channel. Dropping them is the last option, and only after analyzing the effect on fixed costs.
Conclusion
Not all sales are worth the same. Knowing which products and customers actually make you money changes how you set prices, grant discounts, allocate sales resources, and decide where to grow. If your sales are going up but your profit isn’t, the answer is probably in the detail of your profitability.
At Total Consulting we perform financial and profitability analyses so companies can decide with reliable numbers, through our Strategy and Finance service. If you want to know where your company makes and loses money, schedule a free diagnostic session.
