Slippery Rock Gazette

Rick Phelps

Synchronous Solutions

In Part One of this article that appeared in the January Slippery Rock, I showed how your fabricating shop’s contribution margin can be used to build financial guard rails to maintain your business profitability as it grows. If you haven’t read Part One, read it now before proceeding.

In Part Two I will show you that while the margin is important, the velocity of that margin flowing through your shop is equally important. It is not just HOW MUCH your product margin is, but HOW FAST you can get it through your shop that matters.

To do this, I want to go back to the example in Part One where the shop owner stated “To be profitable in this business you need to have a margin of at least 62%.” In that article I showed a set of circumstances where his business would make 10% Net Profit, and what would be required to get that Net Profit up to 15%.

I believe there is an implication in his statement “You need to have a margin of at least 62%,” that a higher margin is both better and necessary. While a higher margin is definitely more desirable, it is not a necessary condition for a given level of profitability. In fact, there are ways you can lower your overall margin AND increase your profit at the same time.

In last month’s example, the owner needed to increase his revenue by $40,000 per month to move his net profit from 10% to 15%. We calculated this would require one additional job per day if the TVE% and Revenue of these jobs were similar to the existing business.

Let’s look at a different scenario for increasing the profits of the shop. Suppose there existed jobs that could flow through the shop at a rate 50% faster than your current mix, but you would have to lower the contribution margin of these jobs from 62% to 42%. What would happen?

The first thing that would happen is your controller would tell you that you are crazy to even consider it. Be that as it may, keep reading!

First, let’s clarify what “flow through your shop at a rate 50% faster” means. It means at the one production process step that limits the capacity of your shop, these jobs go through 50% faster. It means the changes you make at your constraint will yield 1.5 of these jobs in the time it now takes to do just one of your typical jobs.

Using the exact same capacity found in Part One to process the extra $40,000 in revenue of existing work, the shop can now process $60,000 in revenue of this new work. Will we come out ahead or behind?

Producing an extra $40,000 in revenue of the existing work with a contribution margin of 62% will yield an additional contribution of $24,800 ($40,000 x 0.62). Producing $60,000 in revenue of new low-contribution margin work yields an additional contribution of $25,200 ($60,000 x 0.42), an increase of $400 to the bottom line.

This new configuration of the business has an average contribution margin of just 59.3%, down from 62.0%, and yet is making more money!

Kinda breaks your brain, doesn’t it?

The implication that a higher contribution margin is necessary to be profitable at a given level is not true. This must mean that contribution margin does not tell the whole story. What does?

Velocity.

The question isn’t simply how MUCH contribution margin is flowing through your shop, but also how FAST that contribution margin is flowing at the one point that matters: your production bottleneck (Constraint).

There are shops with a very high contribution margin (> 70%) that are not making any money because it takes too long to produce each job, making the daily FLOW RATE of money too low to cover operating expenses.

Conversely, there are shops with a low contribution margin that are making great money because they are so efficient in how they process jobs that their FLOW RATE of contribution margin at their Constraint is really high compared the outflow rate of their operating expenses.

Once again, the importance of understanding your product margin isn’t about comparing it against some benchmark or “ideal,” it’s about knowing what you must do in your shop to make the profit levels you want.

The financial guardrails discussed in Part One are what enable you to determine the velocity of flow through your shop to make the profits you need or desire.

Helping fabricating shops grow their business from where they are to where they want to be is what Synchronous Solutions is all about. If you want help increase the flow of work and money through your business, we’d love to talk to you.

If this makes your brain hurt, but you realize it’s important, visit (https://synchronoussolutions.com/free-resources/) to watch our video explaining in a little more detail how this all works.

Helping fabricating shops grow their business from where they are to where they want to be is what Synchronous Solutions is all about. If you want help working through these calculations in your business, contact us at www.synchronoussolutions.com  or give us a call at 216-533-1387.