SKU Profitability Analysis: A Step-by-Step Method

SKU profitability analysis calculates what each stock-keeping unit earns after all the costs it causes, including the cost of holding the inventory, and it is the analysis that most often reveals that the long tail of a range is consuming more than it contributes. A SKU can show a positive gross margin and still lose money once picking, freight, returns and carrying costs are counted, and a SKU with modest margin can be a star if it turns quickly. This guide sets out seven steps, works a three-SKU example that includes inventory carrying cost with checked arithmetic, and gives rules for deciding which SKUs to keep, fix or exit. It belongs to unit economics and budgeting and forecasting, builds on product margin analysis and operating margin, and leads to customer profitability analysis and channel profitability.

Why SKU level matters

Averages across a product family hide the tail. In many ranges, a small number of SKUs generate most of the contribution, while a long tail of SKUs sells slowly, ties up cash in inventory, complicates forecasting and warehousing, and still gets marketing and operational attention. The only way to know which is which is to calculate profitability for each SKU on a consistent basis.

The seven steps

1. Build a clean SKU list

Include every active SKU with its category, unit cost, price, dimensions and weight, launch date and status. Remove duplicates, merge variants that behave the same (for example colors that are not forecast separately) if that matches how you plan, and flag new SKUs, which need a different treatment because they have not yet had time to sell.

2. Calculate net revenue by SKU

Use actual sales for the last twelve months, net of discounts, returns and allowances. A twelve-month window covers seasonality. For seasonal SKUs, use a full cycle.

3. Add product cost

Use the actual landed cost per unit, not an outdated standard cost. Include freight, duties and packaging. See landed cost.

4. Add the costs that vary by SKU

Costs that differ by SKU: pick and pack (by lines or size), outbound freight (by weight or dimensions), returns rate and handling cost, payment fees, marketplace fees, commissions and SKU-specific promotions or marketing. Use drivers that reflect cause. A bulky, heavy, fragile SKU costs more to ship and return than a small one with the same price.

5. Calculate unit and total contribution

Contribution per unit is net price less product cost and other variable costs. Total contribution is that figure times units sold.

6. Charge for carrying inventory

Inventory has a cost: the cost of capital tied up, storage, insurance, handling, shrink and obsolescence risk. Many companies use an annual carrying cost between roughly 15 and 30 percent of inventory value, depending on their cost of capital and storage costs, but use your own estimate. Multiply the average inventory value of each SKU by the carrying cost rate.

7. Rank and decide

Calculate contribution after carrying cost, inventory turns and, where space is tight, contribution per cubic foot or per pallet position.

A three-SKU example

Assume a carrying cost of 25 percent a year. Figures are illustrative.

Check: X: 10,000 × 6 = 60,000; 1,000 × 15 = 15,000; 15,000 × 0.25 = 3,750; 60,000 - 3,750 = 56,250; turns = 150,000 / 15,000 = 10. Y: 1,200 × 9 = 10,800; 900 × 30 = 27,000; × 0.25 = 6,750; 10,800 - 6,750 = 4,050; turns = 36,000 / 27,000 = 1.33. Z: 300 × 12 = 3,600; 400 × 40 = 16,000; × 0.25 = 4,000; 3,600 - 4,000 = -400; turns = 12,000 / 16,000 = 0.75.

SKU Z has the highest contribution per unit ($12) and a loss once carrying cost is counted. SKU Y has a better unit contribution than X and earns one-fourteenth as much after carrying cost. The unit contribution ranking (Z, Y, X) is the reverse of the ranking that matters for the business (X, Y, Z). This is the main reason to include inventory in SKU analysis.

Rules for deciding

Exiting SKUs releases cash. In the example, discontinuing Z and selling off its $16,000 of average inventory returns cash and removes $4,000 of carrying cost. Do check halo effects: some SKUs earn their place by completing a range or serving a key customer.

Constrained resources

When shelf space, warehouse slots or production capacity is limited, rank by contribution per unit of the scarce resource. Suppose SKU X takes 1 pallet position and SKU Y takes 1.5. Contribution after carrying cost per position is $56,250 for X and 4,050 / 1.5 = $2,700 for Y. The pallet positions would earn far more if given to X's replenishment frequency.

Data and tools

You can build the analysis in a spreadsheet for up to a few thousand SKUs, using a table with one row per SKU and formulas for each step. For larger ranges, use a database or business intelligence tool, with the same logic. Automate the data pull so it can be refreshed monthly. Tie the total back to the income statement as a check.

Link to demand planning

SKU profitability and demand planning inform each other. Planning decisions on safety stock, order quantity and range depth affect carrying cost and stockouts, and profitability shows where accuracy matters most. Use the analysis to set differentiated service levels by SKU class. See demand planning and inventory optimization.

Common mistakes

• Using standard costs that no longer reflect reality.
• Ignoring returns and freight differences between SKUs.
• Leaving out inventory carrying cost.
• Judging new SKUs on the same basis as mature ones.
• Cutting SKUs that serve as traffic drivers or complements.
• Running the analysis once and never again.
• Using revenue-based allocations that hide the differences.

Grouping SKUs into classes

With dozens or hundreds of SKUs, group them by importance so that policies can differ by class. A common approach ranks SKUs by contribution after carrying cost and divides them into A, B and C classes. In an illustrative range of 100 SKUs, Class A might contain 12 SKUs that produce 68 percent of contribution, Class B 28 SKUs that produce 24 percent, and Class C 60 SKUs that produce the remaining 8 percent. The classes call for different treatment: tight availability and frequent review for A, standard policies for B, and a regular challenge to the existence of each SKU in C. Combine the profitability class with demand variability to set service levels and safety stock. See demand planning and inventory optimization.

New, seasonal and replacement SKUs

Do not judge new SKUs against mature ones. Give each a defined test period with targets for sales rate and contribution, and review at the end. Seasonal SKUs should be judged over a full season, with carrying cost based on the time the inventory is actually held. Replacement or successor SKUs should be analyzed together with the item they replace, since sales of one cannibalize the other. A good practice is to require a business case, including expected contribution and inventory investment, for every new SKU before it is added, and to check it against actual results after six or twelve months.

FAQs

What is SKU profitability analysis?

A calculation of how much each SKU contributes after the costs it causes, usually including inventory carrying cost, used to decide which SKUs to keep, fix or exit.

How do I calculate SKU profitability?

Subtract product cost and other variable costs from net revenue to get contribution, then deduct inventory carrying cost based on average inventory value.

What carrying cost rate should I use?

Use your own cost of capital plus storage, insurance, handling, shrink and obsolescence. Many companies use something in the range of 15 to 30 percent a year, but yours should be estimated from your data.

Should I drop all unprofitable SKUs?

No. Check for fixable pricing or cost problems, halo effects on other products and strategic reasons before exiting.

How often should I run a SKU profitability analysis?

Quarterly is a good rhythm for most companies, and after significant cost or price changes.