The Importance of Understanding Product Margin: Part One
Rick Phelps
Synchronous Solutions
When networking with other fabricating shop owners you might get into discussions about what it takes to make a profit in this business. You might also see benchmarking data that you are trying to relate to your business and your situation. What I want to do in this article is explain how to understand YOUR numbers so you can compare them to others’ numbers if you must.
One key financial metric that gets kicked around a lot in these discussions is ‘Margin’. I overheard one shop owner emphatically tell those listening at the bar that ‘to be profitable in this business you need to have a margin of at least 62%’. In this instance, I believe he was referring to the metric Gross Margin.
There is more than one correct way to calculate Gross Margin, so for this article to make sense I need to define some terms. Read these definitions carefully because they may not be your definition of the terms.
Gross Margin: The money that remains in the business after the Cost of Goods Sold (COGS) is deducted from Revenue.
Gross Margin = Revenue
– C.O.G.S.
C.O.G.S.: Material, Contract and Direct Labor costs of producing a product.
Contribution Margin: The money that remains in the business after the Truly Variable Expenses (TVE) have been deducted from Revenue.
Contribution Margin = Revenue
– T.V.E.
T.V.E.: The money that leaves the business to pay suppliers and contractors when producing a job.
Operating Expense (OE): ALL the money you pay to convert what you buy from suppliers into products or services for your customers. This includes Direct Labor.
The way I have defined Contribution Margin is what we at Synchronous Solutions also call Throughput Dollars. For the remainder of this article, I will be referring to Contribution Margin and not Gross Margin because Gross Margin introduces Direct Labor into the calculation, and Direct Labor has not ‘directly varied’ with output in over 100 years (unless you pay all your direct labor a piece rate and not an hourly wage). Direct labor is for all intents and purposes a fixed cost in every business I have ever worked with.
We have a stated hypothesis: one owner believes you need 62% margin to be ‘profitable’ in this business. What wasn’t stated was what ‘profitable’ meant, so I will arbitrarily define ‘profitable’ to mean 10% Net Profit, the minimum profit to sustain and grow a business over time.
Under what circumstance is this owner correct?
We can rewrite the Contribution Margin formula above as percentages as follows:
Contribution Margin % = Revenue %
– T.V.E. %
And then based on this, calculate what the owner’s TVE must be:
62% = 100% – T.V.E. %
T.V.E. % = 38%
Contribution Margin is equal to the total of Operating Expense plus Net Profit. Therefore, the total revenue your business brings in must end up in one of three buckets based on this equation:
Revenue = T.V.E. + Operating Expense
+ Net Profit
Or, written as percentages:
100% = T.V.E.% + OE% + NP%
Plugging in the numbers, we get:
100% = 38% + OE% + 10%
Solving for OE we get:
OE% = 100% - 38% - 10%
OE% = 52%
What does this tell us?
We deduce from the owner’s assertion that ‘you must have at least 62% margin’ that the percent of his revenue he pays his supplies is 38%, and that to maintain a 10% net profit he must constrain his operating expenses to 52% of Revenue.
All of which adds up to this: the owner’s assertion is likely correct for his exact situation and is probably not at all relevant to your situation. Know YOUR numbers!
Here is what IS important to understand about Product Margin:
Your Product Margin is equal to 1-TVE %, so if your TVE goes down by a percentage point, your margin goes up by a percentage point.
There are just three ways to decrease the TVE %:
- Pay less for your materials.
- Make more effective use of the materials.
- Charge more for your products.
Once you know your Contribution Margin, you can decide what NP% you want to earn and calculate what your limit on OE% must be to achieve it.
Suppose you are that business owner with a 62% Contribution Margin and a 10% Net Profit, and you want to increase your net profit to 15% while assuming no improvement in TVE %. What would it take?
If the Operating Expense of the business is $200,000 per month, then the Revenue must be $385,000 per month ( $200,000 / 0.52 ).
To get to 15% net profit, the Revenue must grow to $425,000 per month with no new OE ( $200,000 / 0.47 ). That is $40,000 per month more Revenue.
If the average job in your shop sold for $3225 it would have a Contribution Margin of $2,000 ( $2000 / 0.62 = $3225 ). This would indicate that you would need to put about one job a day more through your shop to achieve your goal of 15% ( $40,000 / $2,000 = 20 jobs), requiring you to go from 6 jobs a day to 7 jobs a day, a 17% increase in throughput. (For reference, clients that implement Synchronous Flow typically see increases in capacity from 20% to 40% with no additional resources. Getting 17% more through a shop should not be difficult.)
You need to understand the Contribution Margin for your business. It is a function of what you get charged for your materials and what you charge for your products. Clearly you should be working on reducing the former while increasing the latter.
Across the fabrication industry we have seen contribution margins ranging from 50% to 78%, with an average of about 65%. It is mostly a function of the markets served.
What your contribution margin is not as important as understanding the limitations it places on your business. Contribution margin is the sum of OE + NP. Decide what net profit you want to make then do the math to determine the operating expense budget you will have to work within to make it happen.
It has been my experience that most fabricating shops grow without doing this simple calculation to set up the guard rails to keep them on the road to their desired profitability. The result is predictable: as these shops grow without OE guardrails, their profit margins go down as they are eaten up by new expenses.
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 .