May 4, 2015
Most business owners and managers with sales responsibility know their sales numbers.
They can tell you their revenues year-to-date for the quarter, for the month, sometimes even for the day.
Unfortunately, many of those same people can’t tell you what their margins by product line are. They are focused on revenues more than profits, and that can be a bad thing.
The general equation for profits is: revenue – variable costs = contribution margin. Then, contribution margin – fixed costs = profits.
Measuring revenue is relatively easy. If you sell a product or service and produce an invoice, you’ve booked revenue.
Contribution margins are more difficult to measure because you have to have a clear understanding of the costs of producing the product. This is often a moving target.
For example, if you are in an industry where the price of raw materials fluctuates significantly, keeping up with your contribution margins can be difficult.
Today, it may cost you $200 to produce Product X. Tomorrow, that same product may cost $260 to produce. Market sensitivity may make it difficult for you to increase your price to your customers, so you have to be able to absorb the difference.
Not keeping up with your contribution margins can mean you’re selling yourself right into a black hole. For instance, let’s say Item A is priced at $750, with a contribution margin of $40 per unit. Item B is priced at $250 with a contribution margin of $95 per unit.
Based on current production levels, $45 per unit produced is needed to cover fixed costs. It’s easy to see that the higher priced item, while it increases revenues faster, doesn’t contribute anything to the bottom line. In fact, it reduces your bottom line $5 for every unit you sell. You’re selling yourself out of business.
Focusing on profits will force you to look more carefully at your overhead costs.
If your salespeople are paid on revenue, they will obviously focus on the higher revenue product, which will drive sales of the unprofitable item. If they are paid on margin, they’ll focus on the items you most benefit from selling, in this case, Item B.
Obviously, there is a balance. It may be that you need to provide Item A as a service to your customers or to keep them from going to a competitor. That’s fine, as long as you know the true picture and balance your sales to accommodate the loss on that item.
Alternatively, you should look for more efficient ways to produce Item A or work on ways to better spread the fixed costs over units of production.
Your accounting system can help you to monitor contribution margins by product lines if it is set up correctly. The old adage of “garbage in, garbage out” certainly holds true here.
You’ll want to study your cost structure and set up your system to accurately report those numbers. Otherwise, you may be making decisions based on bad information.
We can help you analyze your costs and set up your system appropriately. It will be important to keep the system up-to-date since prices of raw materials and other supplies change. As stated earlier, it’s a moving target.
Focusing on profits will force you to look more carefully at overhead costs. The better you can manage fixed costs, the more profit you can take to the bottom line.
Look for costs that fail to add value and work to eliminate them. Fine tune your processes so that you can provide the necessary functions at a reasonable cost. Don’t get so cost conscious that you undermine the quality of your product or service, but be smart.
Bottom line, paying attention primarily to revenues can be a big mistake. Managing your bottom line by paying attention to profits is a wiser choice.
This article was originally posted on May 4, 2015 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.