contribution margin

Improve Profits by Process Improvement

by Tom Gray | on Jan 13, 2012 |  Comments

One of the best ways for small business to improve profits is changing processes to use less variable costs: less labor or materials, less subcontractor cost, less shipping cost. The result is a higher contribution margin.

Process improvement is the BEST technique for profit improvement because it produces more profit with EVERY sale. Unlike a reduction in fixed costs, process improvement generates more and more profit as the business grows. Unlike a price increase, it does not threaten sales volume.

Process improvement increases the contribution or operating margin, in both dollars and percentage of revenue. As sales increase, profit increases, while fixed costs stay the same. Profit becomes a higher and higher percentage of revenue, while fixed or overhead costs become a lower and lower percentage of revenue.

The goal is a substantial change in profit, so look for changes with substantial profit impact!

Start With a Flowchart: The “Process Map”

Process improvement starts with understanding the process itself. The best way to do that is to map the process using a flowchart, a process map.

You can draw this process map by hand, or use an MS Office program called Visio, or even PowerPoint. A good tutorial on process mapping can be found at Balanced Scorecard’s “Handbook for Basic Process Improvement”, especially pages 21-24 in the PDF page count.

This technique works well for both service businesses and production environments. In a job shop, you will start with your Bill of Materials (BOM) and routing sheet. Of course, you will want to make sure they are accurate first!

Your goal for process improvement is substantial change. You want to reduce the costs and time involved by 25 to 50% or more. A faster process reduces inventory holding costs as well as labor hours, and may improve cash flow as well. Faster production can also be a competitive advantage.

Process Map Techniques

To improve your process, pay special attention to opportunities to reduce customization, handoffs, inspections, and approvals. These all introduce delay and overhead. To enable this type of examination, make sure your process map displays each of these time-wasters as they exist in your process today.

The first version of your process map will show the movement of materials and all the major steps of processing them, all the way through shipment. You will show decision points as diamonds with yes/no branches, leading to various alternative outcomes.

The second version of your process map will add notes to show how long each process step takes, how long production waits between steps, and what percentage of the jobs use each branch (such as rework after inspection). It is also a good idea to show the flow of paperwork generated by each step.

Process improvement is the route to substantial change in variable costs and long-term profit. It starts with a process map so you can see what might be changed. The next two articles will explain eleven techniques for improving your processes.

Have you ever done a process map? Did it help your analysis? What tips can you offer? Send your comments!

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), and a SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. For information on the scope of Tom’s activities, see www.tom-gray.com. For more on SCORE services, see www.scorefoxvalley.org.

 

The Easy Way to Use Your Numbers, and Survive

by Tom Gray | on Jan 06, 2012 |  Comments

“But I hate numbers; I like people,” said the small businessman. Then that no-longer-so-friendly banker called to say the loan payments were late, and the owner had to let some of his now-disappointed staff people go, and he had to get stricter with some of those nice but late-paying customers, and the ones who always came back for changes and even returns.

What happened? He ran the business like a social club, where relationships are all that matter. But a business needs cash to run. Without cash, the relationships disappear. When cash flow was weak, the foundation was tottering, but he refused to look down there. “Every time I look down there, I have to study things and make unpleasant decisions, so I don’t look any more. I just let my accountant look.”

If you don’t attend to your numbers, your business will fail. You should be eager to see how you’re doing! And eager to fix any problems, so the business can go on. It’s not hard to assess your business financial health, if you focus on “percent of revenue.”

You don’t need expertise in bookkeeping if your results are presented in a way that enables planning. You want these numbers to stand out: percent of revenue for every line, and the key lines are total variable costs, total fixed costs, and contribution margin. For a good way to present the information, see Owning Your Own Business Means Owning Your Own Books | Thomas H. Gray – Consultant, CEO, Director.

With your data in Excel, you can experiment. Copy it onto a new worksheet, or save it under another name, and then change the data to see how changes in your business would affect the bottom line — profit.

Sample Analysis: Profit Up 20%!

Assume you want a minimum profit of 10% of revenue, which will be something like 7.5% after income tax. If your fixed costs are 30% of revenue, then your contribution or operating margin MUST be 40% of revenue to cover that 30% overhead and leave a 10% profit.

If you can cut overhead from 30% of revenue to 25%, your profit goes up from 10% to 15%. Review your overhead or fixed expenses to see what changes make sense.

  • You’ll see that small changes, such as not buying soda for the office refrigerator, have little or no impact.
  • If you cut marketing (probably no more than 5% of revenue), what will happen to your flow of new customers? Is such a cut worth the risk?
  • Maybe you can reduce nonproductive labor hours by changing work schedules. This is always worth examining. If this number is 5% of revenue including payroll taxes, cutting it to 3% raises profit by 2% of revenue, which is a 20% increase in profit from 10% to 12%! “Thanks for the raise,” says the owner.

Analysis Techniques

Variable costs and revenue are usually the most fruitful areas to consider. The FIRST technique here is to understand the profitability of each product or product type. On a separate worksheet in Excel, consider each product type. Show the revenue for one unit, and the variable costs to produce it. Subtract costs from revenue to see product profit, and then show that as a % of revenue.

If this product profit is more than 40% — your 10% profit target plus 30% for overhead coverage — great! If it is less, you must do something. Your choices are: raise the price, reduce the variable cost, stop selling it, or accept a profit lower than your target.

  • If you stop selling it, and you can replace the revenue by selling more of other products, your profit will increase as a % of revenue.
  • If you can reduce the variable costs for the product, your profit will increase as well.
    •  One technique is to pay less sales commission on less profitable products – change your commission structure to be different per product.
    • Another technique is to change your production process. This is the BEST approach, and there are many techniques. They all start with mapping out the process as it is today, and then imagining what might be changed. See
    • A third technique is to move some subcontracted work in-house to use nonproductive hours, or move some work to other suppliers if you can offload the associated payroll hours. See Process Improvement | Thomas H. Gray
  • Raising the price is the FASTEST way to improve profitability. A small price change may not be a problem for your customers, yet it will have a major effect on profit. For example, a 5% price increase would raise profits from 10% to 15%, a 50% gain! Even if you lost a few customers, the gain may be worth it. See Pricing Tips: Start High; Big Results from Small Changes | Thomas H. Gray – Consultant, CEO, Director.
  • You can use Excel to change the price and revenue per product, and reduce the number of units sold to see how many sales you could afford to lose yet still be better off.

A word of caution: be careful of major investments that you hope will solve the problem. Examples include a major machine purchase, a major new marketing program, or moving to a larger newer location. They deserve their own careful analysis of costs vs. likely benefits. Your entrepreneurial optimism might be your own worst enemy with such major commitments!

Your numbers are begging for your attention! They control the life and death of your business. It’s not hard, if the numbers are presented the right way. When variable costs, fixed costs, and margins are presented in terms of % of revenue, you don’t have to be a bookkeeper or love numbers to see what’s out of line.

Have you tried this?  What did you learn?

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com

Owning Your Own Business Means Owning Your Own Books

by Tom Gray | on Jan 05, 2012 |  Comments

Most small business owners don’t understand bookkeeping, Quickbooks, contribution margin, or cash planning, so they shy away from learning how to use their results to improve the business.

Yet when small businesses fail, it’s because they run out of cash. Why does this happen, and why do owners allow cash shortages to develop in the first place? Too often, it’s because they don’t try to understand their numbers.

They assign someone else to “keep track” of the numbers.  Unfortunately, bookkeepers are not planners. Bookkeepers look backward, not forward. Owners are the only ones whose job includes using past performance to improve future results, but they usually do not know how.

The owner is the expert on what the business does, spending up to 80 hours per week to make sure the business has effective operations, and maybe even spending some time on getting new customers. Small business owners typically do not make it a priority to understand their numbers well enough to predict their future. Short term demands make future planning seem like a low priority. Then they run out of cash!

Fortunately, it is not difficult for small business owners to understand their numbers well enough to plan, even without learning software (e.g., Quickbooks) or bookkeeping. Three techniques are all they need.

  • First, require the bookkeeper to export the monthly Quickbooks Profit and Loss Report to an Excel spreadsheet with one column for each month of the year.
  • Second, have the bookkeeper reformat the data in Excel into an Income Statement with a reasonable number of revenue and expense categories (see below), and for each category heading show the “% of Revenue” in that line.
  • Third, study where the money goes and create ideas to change those percentages.

Let’s look a little deeper at each of these techniques. First, the Internet has dozens of entries telling the bookkeeper how to export data from Quickbooks to Excel.

Making Quickbooks Reports Manageable

In the second task, you are making the Quickbooks data more useful by reducing the number of entries to a manageable number. For revenue, you should have a summary line for each product type. Even in a job shop, you can categorize your jobs into types.

The next main category is variable expenses, or Cost of Goods Sold (COGS). Your lines for variable costs will be labor (and associated payroll tax and possibly benefit costs), materials, subcontractors, shipping, and sales commissions. The labor line will include labor costs devoted to production, with nonproductive labor hours shown elsewhere as overhead costs.

The last major category is fixed or overhead expenses, those that stay the same regardless of production volume. Here is where you will invent headings and summary lines to group costs by type, so the number of lines is manageable. Ten categories should be sufficient. For example,

  • Nonproductive labor/tax/benefits
  • Salary/tax/benefits
  • Facility costs (rent, maintenance, utilities)
  • Computer costs (hardware, software, maintenance)
  • Vehicle costs
  • Office expenses (include phone and bank charges)
  • Professional services (accountant, legal, consultants)
  • Marketing costs (include travel and entertainment)
  • Dues and Licenses (professional licenses, conferences, dues and subscriptions)
  • Miscellaneous – but try to keep this minimal!

This is a lot easier to work with than 30 or 40 accounts, most of which say 0 for the month! If it is easier to work with, there is a better chance you actually will work on it!

Analyzing the Results

The third technique is analyzing the results. This is the owner’s job, and no one else’s. Up to this point you have simply been telling the bookkeeper to present the data in a more useful way

Analysis starts by looking at % of revenue for each line. The key line is “contribution” (to cover overhead and provide profit), also called gross margin. This is revenue minus variable costs, or revenue minus COGS to some accountants.

Hopefully this margin is at least 50% of revenue. Why? This margin is what you have left after building the product, and its job is to pay for overhead and leave a profit. If your margin is 50%, and your overhead is 30% of revenue, then your pre-tax profit is 20% — a good number.

Numbers are the way we keep score. Without them, you can’t know if you are winning the game or losing, until it is too late! Small business owners can avoid a cash shortage without expertise in bookkeeping. The secret is to present their results in a way that enables planning, using percentage of revenue and contribution margin. In the next article, we will discuss how you can use this data to improve your business.

Does this seem do-able so far? Does it seem worth doing?

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com