Will Culling Low Margin Items Actually Destroy Profits? An Exploration into Economies of Scope

The question was posed: “We have some low margin products.  Our OPEX is 12%.  Should we conduct a product portfolio rationing and cull all products with a margin below our OPEX? When should we pull a product?”

It seems obvious at first glance that one should not sell offerings that can’t achieve a margin above the operational expenditures (OPEX).  Yet what appears obviously true can be wrong.

Operational expenditures are the firm’s fixed costs.  While a simple exploration of the profit equation of the firm under varying prices demonstrates that the firm’s fixed costs, as long as they are truly fixed, have no impact on an optimal pricing decision, that isn’t the same as stating that low margin items should or should not be culled when their margin falls below the firms’ OPEX expressed as a percentage.

In fact, a simple thought experiment will demonstrate that pulling low margin items can harm a firm’s profitability, even if the margin of those items falls below the OPEX expressed as a percentage of revenue.  Let me demonstrate.

OPEX and Low Margin Items

Consider a simple and lean firm with an OPEX of 12% and product portfolio consisting of only three products: Product Low, Product High, and Product High.

• Product Low, priced at $12, is a high volume product (200,000 units per year) but is considered a commodity and has a low margin of 10%.
• Product Medium, priced at $20, is a medium volume product (75,000 units per year) with some differentiation and has a modest margin of 25%.
• Product High, priced at $40, is a low volume product (5,000 units per year) yet is highly differentiated and can command a high margin of 50%.

See the table below for a summary of the product portfolio’s performance.

As long as the firm sells the entire product portfolio, it earns $223 thousand in profits on $4.1 million in revenue.  The 12% OPEX translates into $492 thousand dollars in operational expenditures.  (I did say it was a lean firm.)

If a product rationalization was to take place wherein finance, sales, and marketing department agreed to cull all products with a margin below OPEX, this firm would drop Product Low.

Without Product Low, revenue would decrease to $1.7 million.  Moreover, the firm would have the dollarized operating expenditures, for they are fixed, but spread over less revenue.  The result would be that the operating expenditures, as expressed as a percentage of revenue, would increase to 29% and worse, the firm would now be operating at a loss of $17 thousand.

If this firm then takes steps to cull further products whose margins fell below the OPEX, they would now need to stop selling Product Medium.

The result is a death spiral killing revenues and profits as further and further products are culled, and eventually killing the firm.

No. Killing products simply because their margin falls below OPEX is a bad idea.  It may seem to be a good rule but, as the thought experiment demonstrated, it can be a horrible strategy.

Economies of Scope

The thought experiment on margins and OPEX is actually an example of economies of scope.  Firms will often develop an infrastructure (asset) which can be used for multiple purposes.  By leveraging that same infrastructure over several items, the overall profit of the firm can be improved.

Economies of Scope were first popularized with respect to gas stations and convenience stores. The same location used for selling gas can also be used for selling soda and other consumables, even though, at first blush, carbonated soda and gasoline are unrelated items.  By using that asset for multiple purposes, the fixed costs of that asset get spread over a larger number of items and the overall profits increase.

Economies of scope are distinct from economies of scale.  Scope economies refer to increasing the breadth and variety of business while scale economies refer simply to increasing the volume of business.  They are distinct.

Pre-cull, our thought experiment firm was benefiting from economies of scope.  Post-cull, the scope of the firm’s activities was reduced and with it went the firm’s profits.

If not OPEX, then What?

If margins below OPEX is not a tell-tale sign that a product should be pulled, then what is?  Or, more broadly, how should executives rationalize their product portfolio?

First, some proactive guidelines:

• Never sell standalone offerings at a negative margin.
• If you must sell a low margin item, do it in conjunction with the sale of a high margin item.
  • Can the product be sold in a bundle in conjunction with a higher margin item? If customers want the low margin item, they can purchase it but only in conjunction with higher margin items through the bundle. This approach ensures that customers aren’t just cherry-picking the cheapest items while giving their more profitable sales to a competitor.
  • Can the low margin item be sold as part of a subscription that includes other, higher profitability, offerings? Or, is the sale of a low margin item probabilistically connected to the sale of a higher margin item?  Once again, this creates a tied, or loosely tied, purchase arrangement but the difference is that the timing of purchases need not be concurrent.
  • Can the low margin item be sold at a higher price but with a rebate which is contractually extended, automatically, only if the customer purchases an overall portfolio which includes a sufficient quantity of higher margin items? This is perhaps the most flexible approach to tying the sale of low margin items to higher margin items.
• Don’t pay salespeople good commissions on bad sales. Salespeople should have a higher commission rate on higher margin items and a lower commission rate on lower margin items.  And, if the margin is zero or negative, the salesperson should not earn any commissions on that sale at all.  (Firms shouldn’t pay salespeople to create losses.) The textbook approach to implementing variable commissions, as well as restrain price concessions, can be found in our white paper on Understanding Deal Points: An Approach to Profit-Based Sales Incentives (or in my textbook, Pricing Strategy).
• Don’t spend marketing time, dollars, or space on low margin items. Once again, this is about not driving the firm towards lower margin sales and, instead, aiming the firm towards higher margin sales.  Marketing communication should focus on the offerings which enable the firm to profit.

And now some reactive guidelines:

• If you will never make money on the product and it cannot be tied to a more profitable offering, kill it. This is indicating that customers have found a more efficient means of attaining that product or achieving their goals than what the firm can deliver.
• If it serves a customer segment that can’t be served profitably, then kill it. This is indicating that the entire customer segment has found a more efficient means of achieving their goal than what the firm can deliver. As in the prior case, the firm is operating at a competitive disadvantage.
• When the costs of selling that product exceeds the profits on that product, kill it. To make this determination, OPEX has to be broken down into buckets representing the “Cost of Sales” and “All Other Fixed Costs.” This is similar to not commissioning salespeople for unprofitable sales and not spending marketing dollars on unprofitable offerings.

Firms often sell low margin items because customers seek the low margin items and, when buying, buy higher margin items as well.  These low margin items can make sense through their enablement of the firm to profit from economies of scope.  Killing low margin items can make sense in some cases, but other cases doing so will kill the firm.

Avoid the death spiral associated with simple rules.  Think deeply and run the scenarios, rationalize or redesign offering portfolios accordingly, and align your sales and marketing dollars to your profits.  This should produce a more profitable outcome than simply “cutting the tail” of low margin items.