In this podcast episode, we cover the issues to consider when you are thinking about cancelling a product. Key points made are noted below.

The Need to Cancel Products

If a company has more than just a few products, it’s likely that a couple of them bring in most of the profits, and the rest are hovering around the breakeven level. This brings up an issue for the controller, who may want to recommend that some of those marginal products be eliminated. By doing so, it’s easier to focus on the few products that earn the company most of its profits, and frees up more staff time to work on new products that may be more profitable.

This sounds simple, but it’s actually quite a bit more complicated, because you need to think through not just the cancellation calculation, but also the ramifications of dropping a product.

The Cancellation Calculation

So let’s start with the cancellation calculation. The goal is to cancel anything that is outright losing money, but which ones are those? To calculate a profit or loss for this purpose, you only include those expenses that are totally variable. This includes things like the cost of materials, and the salesperson’s commission, and any processing work charged by a third party, and the packaging cost.

There’re two expenses that you do not include in the calculation. One is direct labor, and the reason is that most companies have the same group of direct labor staff come in every day, and they work a full day on whatever is in front of them. If a single product is cancelled, then they’re just going to work on something else, so canceling the product does not terminate the people who manufacture it. On the other hand, if employees can be specifically identified who do work on a product, then fine – go ahead and include them in the cost.

The second expense that you do not include in the calculation is overhead. Overhead is usually things like the plant management group, and depreciation on equipment, and quality assurance staff, and supplies, and so on – and none of these expenses will change if one product is cancelled.

If you were to do a product cancellation calculation with overhead, and the overhead expense is what tips the product over into the loss column, then all you’ve done is eliminate a profitable product – and then the overhead, which is all still there, is now spread across the smaller number of remaining products, and that in turn makes them look less profitable. So in short, avoid overhead.

However, if you’re analyzing the cancellation of an entire product line, rather than single products, then a fair amount of overhead can be applied to the calculation. For example, you can include the cost of marketing the product line, and procurement, and the cost of the product manager. These all make sense, because if you cancel the entire product line, then these expenses will go away.

Now, if the analysis shows that there is a loss, you’re not really done with all of the analysis, because there’s also exit costs. First, there may be a fair amount of inventory in stock, so you may want to calculate how long it will take at the current sales level to work the inventory down, so you can recommend a termination date.

And the same thing goes for fixed assets. If there’s manufacturing equipment that the product is made on, and it’s scheduled for an upgrade or replacement, then you need to get the word out to prolong the maintenance on what you already have, until the scheduled termination date. This is a lot less expensive than buying new equipment that the company will just have to turn around and sell in the near future.

And also, what if there’s a warranty period on the product, like a year? For that period, you need to estimate the amount of inventory that you’ll probably need, and set it to one side.

These exit costs don’t really have an impact on the decision to cancel a product. But what they do have an impact on is the timing of the cancellation, so you do need to work through these issues – not just once, but probably once a month as the cancellation date gets closer.

For example, you might find that sales of a product decline over time, so you may decide to extend the cancellation date further out to use up the last of the inventory. That’s the sort of decision that requires continual updating.

So let’s say that you’ve done all of the analysis, and you know what to cancel and when to do it. You still need to consider the ramifications of the cancellation.

The Ramifications of a Product Cancellation

One issue is that a clearly unprofitable product may the lower step of an upgrade path to another product that’s much more profitable. If so, add together the profitability of both products. If you still come up with a loss, then the upgrade argument doesn’t work, and you should still cancel the unprofitable product.

The same argument applies if an unprofitable product is crucial for the overall business of a customer who otherwise generates a lot of profit for the company. If this is the case, make sure that the customer is really as profitable as you think. If it is, and the customer insists on having that product, then you’re probably stuck.

And then there’s the product line issue. A company may want to offer a complete product line, and if one product is unprofitable, then canceling it creates a hole in the product line, and perhaps a competitor could take advantage of that. If so, the best approach is a long-term one, where you recommend that a product be developed that has a lower cost structure. Then you cancel the old product when the new one is ready.

If you’ve gone through all of these calculations and analysis, there probably won’t be very many products left to cancel. But, running a business is a bit like being a doctor, and their motto is first, do no harm. The same principle applies in this situation. You don’t want to slash and burn the product line. Instead, it should be a careful review of the situation, and you only cancel as a last resort, when there’s really no alternative.

And that’s why I’ve done about a hundred product cancellation reviews over the years, and only recommended that two of them be eliminated.