Right mix in product line design increases profits for the firm

Determining the right mix of products to offer in the marketplace has long been considered the purview of a firm’s marketing team. Research conducted by Panos Kouvelis, Ph.D., a professor of operations and manufacturing at the Olin School of Business at Washington University in St. Louis, reveals that operational implications of product line decisions are not to be overlooked. Kouvelis shows that integrating marketing strategies with manufacturing and supply chain efficiencies serves to maximize profitability. His model for product line selection accounts for both diverse customer preferences and manufacturing costs that vary with product line composition.

Typically, companies emphasize the marketing aspects of product line decisions, with managers focused on increasing competitive advantage by broadening the product line to satisfy demands for increasingly differentiated customer segments. The resulting proliferation of product lines generally ignores the impact on the company’s manufacturing costs. Thus, the incentive for marketing managers to increase market share or sales from new products obscures costs associated with inefficient manufacturing performance, which must now accommodate more complex interactions among products.

Panos Kouvelis

“Crest and Colgate toothpastes, for example, both available in more than 35 types and package sizes, have increased their market shares in the last decade at the expense of smaller brands unable to keep pace with the new offerings,” said Kouvelis, Emerson Distinguished Professor of Operations and Manufacturing Management. “However, their supply chain costs, either manifested as excess inventory, frequent switchover costs, or shortage costs of popular stock keeping units (SKU), have increased at an accelerating rate to the number of SKUs.”

Consumer product companies, such as Colgate Palmolive, have learned the lesson the hard way, mounting efforts to create narrower and better-focused product lines. “Smith Kline Beecham’s Aquafresh toothpaste line, for example, does not attempt to match the market leader’s line extensions but instead focuses on the most popular offerings of competing product lines,” noted Kouvelis. “This action has reduced the supply chain costs of the firm and increased on a per-SKU basis direct profit for not only the firm, but also the retailer.”

Companies are becoming increasingly aware of the advantage of both offering a variety of products to strengthen their competitive position in the marketplace and designing families of products that have similar manufacturing specifications, said Kouvelis. The product line that maximizes profitability combines the best trade-off between diverse offerings and the savings realized by selecting products that allow for cost-effective production.

One common practice for firms is to customize products toward the end of an otherwise standardized production process. The needed customization is achieved either via the use of fast-paced assemble-to-order techniques or with the use of flexible manufacturing systems. Hewlett Packard has applied such an approach in its printer division for customizing its European market offerings, diverse in terms of language, voltage, and packaging preferences. Similar practices are behind the mass customization practices of Dell computers and National Bicycles, a Panasonic brand of high-end mountain bikes.

Two concepts serve to characterize product interactions in manufacturing. The synergy ratio defines the level of manufacturing commonality of the products. The manufacturing class breadth of a product line measures the diversity of manufacturing requirements associated with the optimal product mix. Together these concepts demonstrate the manufacturing implications that are critical to making the most informed decision in product line management.

Extensive modeling demonstrates that product line profitability improves significantly when decision models incorporate the cost of manufacturing in product costs and exploits the manufacturing synergies among products. “Empirical industry studies have documented such cost increases,” said Kouvelis, “with the unit costs of multi-item product lines suffering 25 percent to 45 percent cost disadvantage relative to the costs of focused product lines on only the most popular items. In particular, the cost per item in a multi-item line indexed to the cost of producing a single item varies from a value of 145 in automobiles, 139 in ladies’ hosiery, 128 in food-service coffee packs, and 125 for baked goods. In other words, cost advantages of 25-45% can be expected for the producers of focused narrow product lines over competitors with highly varied product offerings.”

Product line elements factored into the analysis of the optimal mix include profitability, breadth, diversity of manufacturing requirements associated with the product mix, and the size of the market share achieved. The total contribution to the company’s profits from the product line is calculated by subtracting from revenues its variable costs, holding costs, and individual product and set-up costs.

These costs must be incorporated with product revenue to accurately measure product line profitability. As the level of design commonalities in products increases, the set-up costs for individual products decreases and a greater portion of the total set-up expenditure required is incurred only once for all products in a class. Savings increase even more when manufacturing costs are substantial. In addition, the higher the levels of manufacturing synergies across product lines, the lower the overall set-up expenditures. And as the level of synergies across products increases, the optimal product mix is focused on fewer manufacturing processes in order to maximize those synergies.

“A recent trend among companies in a variety of industries is to carefully rationalize their product lines,” said Kouvelis. “Procter and Gamble has eliminated 25 percent of its slower moving SKUs. Chrysler, following the lead of Japanese producers, is offering mostly ‘fully loaded’ cars with fewer options in a much more customer focused product line,” he added.

Product line selection should capture the trade-off between diversity and the cost reduction realized by reflecting a mix of products that can be manufactured efficiently, Kouvelis concluded. This approach yields the greatest results when manufacturing synergies are considerable and production costs are high. Increased synergies have the added benefit of facilitating broader product lines by reducing individual set-up costs. Generally, product line decisions that are based on maximizing market share without factoring in manufacturing costs do not provide an accurate assessment of a company’s profitability.

“The era of unrestrained line extensions is over,” Kouvelis said. “Firms that align products and production-distribution systems with customer needs will create stronger margins and sustainable long-term shareholder value.”