variable costs

Margin Analysis Drives Pricing

by tomgray | on Mar 28, 2012 | No 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, and sales commission. Owners increase their margins, and hence their profits, by managing these costs to reduce them 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 looks deeper than the business as a whole, 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 to raise 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 (see Pricing Tips: Start High; Big Results from Small Changes) to get the price where it needs to be.

A third technique is to boost the prices and margins for less competitive products. 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.” Another example 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.

 

Improving Profits by Process Improvement

by tomgray | on Jan 13, 2012 | 1 Comments

As noted in Fear of Numbers – Planning beyond Bookkeeping, the best way for small business owners to improve profits is to change processes to use less variable costs: less labor or materials, less subcontractor cost, less shipping cost. The result is a higher contribution margin. The goal is a substantial change in profit. Process improvement is a whole set of techniques. The basic tool is a process map.

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.

Process improvement starts with understanding the process itself. The best way to do that is to map the process using a flowchart. 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 can be a competitive advantage as well.

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 branches for options, and decision points with yes/no branches.

The second version will 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 is a management consultant focused on small business, a Certified Turnaround Professional (CTP), and a SCORE Mentor.  He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com

 

Profit Planning not Bookkeeping: Percentage of Revenue

by tomgray | on Jan 05, 2012 | 1 Comments

Small business owners can avoid a cash shortage and manage profitability without expertise in bookkeeping, if their results are presented in a way that enables planning, using percentage of revenue, variable vs. fixed costs, and contribution margin. For a good way to present the information, see Fear of Numbers – Planning beyond Bookkeeping.

With your data in Excel, you can experiment by changing the data to see how changes in your business would affect the bottom line– profit.

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 will 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 by2% of revenue, which is a 20% increase in profit from 10% to 12%.

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 it as a % of revenue. If this product profit is more than your 10% profit target, 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. 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.

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. You can use Excel to change the revenue per product and reduce the number of units sold to see how many sales you could afford to lose and 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!

As you can see, you don’t have to be a bookkeeper to make numbers-based decisions when the variable costs, fixed costs, and margins are presented in terms of % of revenue!

Have you tried this?  What did you learn?

Tom Gray is a management consultant focused on small business, a Certified Turnaround Professional (CTP), and a 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 tomgray | on Jan 01, 2011 | 2 Comments

Forecasting sales, revenue, and cash for the next 13 weeks is the most difficult part of the 13 Week Cash Flow Statement for a small business because it is the least certain. See 13 Week Cash Flow Statement. But this task has some easy parts too. The first step is to forecast known revenue and costs – those for outstanding invoices, work in progress, and new work from proposals already submitted.

First, identify the invoiced amounts you have not received yet. Note how much you expect to receive in each week.

Second, consider your work in progress. How much will you invoice for this work? 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. It is good idea to 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. In each case, 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).”

Third, consider the future work you know about. You may have already made a bid or proposal, or you intend to. This should be a third set of rows in your spreadsheet. It’s a good idea to use a separate sheet to estimate the revenue, costs, timing, and percent likelihood for each of these jobs; 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?

The last question may be the hardest: 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.

The final step is to 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 from bids already submitted.

Tom Gray is a management consultant focused on small business, a Certified Turnaround Professional (CTP), and a SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com.