variable costs

Margin Analysis Drives Pricing

by Tom Gray | on Mar 28, 2012 |  Comments

You know your price must deliver enough margin, after variable costs, to cover overhead and leave the target profit you want. This means that margin analysis, i.e., understanding all your variable costs, is crucial to setting your price.

Variable costs are those costs whose amount changes with another sale. They include

  • materials
  • labor
  • subcontracted services
  • shipping
  • sales commission

Owners increase their margins, and hence their profits, by reducing these variable costs on a per product basis. For example, if I cut my variable costs from 55% of revenue to 50%, then my margin grows from 45% to 50%.

Margin Analysis by Product and Customer Group

Margin analysis gets bebeath the Buisness P&L, to assess the margin on each product and each set of customers.

Owners need to know which products have the highest and lowest margins. There may be a role for low margin products, to attract new customers, or fill a hole in the product line. But there may also be opportunities to raise those low margins by product or process redesign, or charging for shipping, or reducing sales commission for such products.

Why pay the same % commission on sales that generate a different % margin? You want salespeople to focus on selling high margin products, and a differentiated commission plan motivates that behavior.

A second technique is raising the price to achieve the desired margin. If it is not making enough money, why are you selling it? Consider using a series of small increases to get the price where it needs to be (see Pricing Tips: Start High; Big Results from Small Changes).

A third technique is to boost the prices and margins for products with little competition. For example, once the customer has bought the main item, you will have little competition for accessories and replacement parts. That means these can be priced with very high margins. One example would be a replacement battery for a laptop computer.

A fourth approach uses innovative bundling. In Know Your Sales Margins – Business Profit Margins | Entrepreneur.com, Randy Myers tells of a company who paired high and low margin products into an offer that produced a higher blended margin. He says “think fast-food value meals.”

Other examples of pairing low and high margin products would be maintenance contracts, or a discount on an already-high list price for replacement parts.

The other direction for margin analysis is looking at customer groups. Some types of customers cost more than others. Reasons may include their need for after-sales support, or warranty replacements, or a lengthy sales cycle, or custom ingredients or processing.

Managing your margins means controlling these extra costs, or charging more to cover them, or even “firing” these customers.

Profitability depends on knowing your margins by product and by customer group. Armed with that knowledge, business owners can focus on which costs to control, and choose prices that deliver their target margin and profit.

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.

 

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.

 

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

 

13 Week Cash Flow, Part 2 – Forecasting the Knowns

by Tom Gray | on Jan 01, 2011 |  Comments

Uncertainty and the variety of potential developments is the challenge in preparing a 13 Week Cash Flow statement. But this task has some easy parts too. The first step is to forecast known revenue and costs – outstanding invoices, work in progress, and new work from proposals already submitted. This part of the process has three steps.

1. Invoices: Identify the invoiced amounts you have not received yet. Note how much you expect to receive in each week.

2. Work in Progress:  How much will you invoice for this work in progress? When will you send the invoice, and how much later will the cash payment be received? Your revenue is booked when the invoice is sent, and this shows up on the “income statement” or “P&L Report”. But for a cash flow statement, the important date (or week) is when the cash comes in. You cannot pay a vendor with booked revenue! You need cash.

This timing difference between invoice and receipt of cash is the most important difference between the income statement and the cash flow statement.

If you expect to pay out additional cash to complete this work in progress, be sure to add that additional expense to your predicted cash outflow for the coming weeks. Use separate lines (rows) in your spreadsheet to show the costs for work in progress separate from the costs of new work you have not started yet.

The typical rows would be materials, labor, and subcontractor expenses, any unusual shipping or packaging expenses, and any sales commissions. These are called “variable costs” or “costs of goods sold (COGS).”

3. Known Future Work: You may have already made a bid or proposal, or you intend to. This should be a third set of rows in your spreadsheet. For each of these jobs, use a separate worksheet to estimate the revenue, costs, timing, and percent likelihood of getting the job. Then you can use a summary on your master spreadsheet.

For this future work, you will need to make some realistic estimates. When will the customer decide? Should you assume he will take the price you bid, or will you need to come down a bit? When will you order supplies and when will you have to pay cash for them? When will you complete the job and invoice it, and when will you receive cash from the customer? If there are “progress payments” along the way, how much and when?

What are your chances for getting each of these jobs? You will multiply each of the revenue and cost figures by this “probability percentage” estimate, making your forecast a more realistic view of the prospects for the business.

Next you will estimate business as yet unknown. We’ll cover that in the next post. At this point you know the format of the 13 week cash flow statement, you forecasted the revenue and costs for outstanding invoices, work in progress, and likely new work you already know about.

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.