Do You Know Your Real Margins?

For business owners, this is a very fluid period of time. The business environment is rapidly evolving. This makes it all the more critical to have a complete understanding of margins and the true costs to produce and sell your product. Do you know what you net out every time you make a sale? In all our time working with businesses, we have found that the response to this question is often not a confident one.

Why does this matter? Understanding your true margins can be key on so many levels, as it will affect pricing decisions, revenue goals, decision making on overhead costs and short- and long-term financial planning, and the way outside investors or lenders will view performance. Businesses every day are leaving money on the table and unknowingly adding risk to their business.

Here are some of the common pitfalls we see:

Too often, margin calculations are inaccurate and inconsistent. First off, many manufacturers will expense goods and labor used in production. While convenient from a time perspective, this distorts the numbers greatly. The goal of good accrual accounting is to present an accurate picture of business activity. So, when a company buys a big order of raw materials the last day of the month, and those materials are used in production the following month, a distorted picture emerges as margins will bounce around materially if the purchase is not appropriately capitalized in inventory. The same thing can apply to a services company based on when payroll is paid. If payday falls on the first of the month, the current month will show higher cost when that labor was actually worked the month prior. It is incredibly challenging for business owners to make good decisions when their margins are swinging wildly month to month.

For companies that have this first piece under control, we still see that many companies calculate cost of goods sold differently. While most include materials and labor, other costs such as freight, storage and factory overhead are a little more hit and miss. For companies that hold inventory, the best way to manage accurate cost of goods sold is to first capitalize to inventory all costs that go into bringing inventory ready for sale – direct cost of materials, production labor, factory overhead, incoming freight and tariffs, storage fees, etc. The second step is to cost inventory off the balance sheet when goods are sold and most accounting systems can be setup to appropriately cost inventory when sold. Factory overhead is a particularly tricky topic as it includes things like rent, depreciation and supervisory labor. When it comes to overhead, what is critical is revisiting an allocation for these items as it will vary based on the volume of production – so for example if sales of goods goes up 10%, rent will likely stay the same, meaning the allocation of rent per unit will go down. Again, what is critical from a management perspective is an accurate picture of the costs incurred to generate a service or product for sale.

Frequently, companies do not look at contribution margins. By definition, contribution margin is revenue less a company’s variable costs. While there can be a little bit of gray area, an easy way to think about this is what costs rise and fall largely in line with sales. This would include direct materials, billable and production labor, freight but also sales commissions, credit card and ecommerce fees, among others. This is particularly valuable in exploring multiple lines of product or services and deciding where to expand or potentially contract. It will provide the ability to understand the breakeven sales required on those same lines, assist in what-if scenarios based on growth and illuminate potential pricing decisions.

Understanding costs is essential to unlocking the potential in a business. Watch them closely, track them diligently and understand how they evolve over time. It could make all the difference, especially in times when top-line is uncertain and input costs are a moving target.

Critical Headlines to Watch

We are still in very uncertain times; headwinds are prevalent, and the daily headlines bombard the small business owner with plenty of potential worries. While talk of a recession is more frequent than it was six months ago, the impact should it occur, will vary by business, industry, and local market. So, what is a business owner to do right now other than just stay the course and power through? There are a few key headlines to watch and understand how they impact your specific business.

Inflation – Supply chain issues are nothing new and have played a role in inflation but there are multiple factors driving inflation overall. There are two areas in which to monitor the impact of inflation. First, what impact is it having on your customers and vendors? For example, some B2C businesses are seeing their customers begin to spend less on certain goods because of the rising prices of food and fuel. Other businesses feel the pain as well. Do you know what impact this could have on your business going forward? Second, understand how inflation impacts the inputs required to run your business on a more granular level. The inflationary outlook is still uncertain, and while broad, commonly measured inflation metrics like the CPI make the first page, it is important to drill down another level. Based on your business, what are prices doing for the raw materials you need and the goods you sell? Some commodity prices like steel have tapered off. Real estate prices in certain markets are showing indications of slowing, while food prices continue to rise. Yes, in general, goods and services are much more expensive than they were a year ago but watching trends on the specific goods and services that go in, out, and around your business is worth regular monitoring.

Interest rates – Rates are increasing. But just like inflation, interest rates is a broad term - what interest rates matter to you? The Federal Reserve raised its Federal Funds rate 0.75% this year. While not across the board, this has resulted in a roughly similar increase that most banks are charging their customers for corporate loans and lines of credit. Home mortgage rates have risen over 2.5% this year, while the 10 year treasury has risen 1.5%. All of these rates are expected to continue to rise but the magnitude is less clear. What impact do higher borrowing costs have on your business? Have you projected the financial impact to your P&L now and in the future? You should, especially in the case of a loan renewal in the near term. What about your customer? We know these increases will affect consumers and businesses. Could borrowing costs impact their ability to buy?

Consumer spending – The United States has been and will be a consumer driven economy. To date, consumer spending has held, as has the overall health of the consumer, in spite of the economic turmoil of the last couple years. It is not talked about near as commonly but a decline in consumer spending is often the canary in the coalmine relative to more serious economic slowdowns, and perhaps a sign for businesses to take more of a defensive stance.

Don’t let the headlines cause fear. Peer through the noise to the key information behind the headlines that affects your business, not just internally, but your customers and the downstream impact on your customer and supply chain. A ten second glance at the headlines may give you a different answer than the data that really matters for your business. Drill down, explore the potential impact, and take action accordingly.

Life after Budget

Hopefully by now the year’s budget was completed months ago and tracking results against it is ongoing.  Unfortunately, for many businesses, once complete, a budget finds its way into a drawer to not be seen again until it’s time for a new one the following year.  As one of the many Budgeting Best Practices we recommend, a deep budget review at end of each quarter end can illuminate key learnings and present an opportunity to revisit assumptions.  Let’s discuss what you can learn and what to do from here. 

How Good is Your Process?

This quarterly review is an opportunity to assess the quality of the budget process itself.  If you are already significantly above or below budget in key areas, that calls into question the validity of the assumptions, the rigor of the process or worst of all, material execution misses.  This might invite a rethinking of planning going forward and can influence future decisions.

Don’t Keep the Budget Open

Some companies don’t finalize a budget until well into the new year, waiting to get the most accurate assumptions or seeking more information.  A budget process should be thorough, but equally important is having a budget in circulation.  It is way too hard to draw a line on when the information is finally “good enough” if there is not a time deadline along with the budget.  Perfection in a budget does not exist, planting a flag in the ground to serve as a true north is key.

Budget vs Forecast

While a budget can be viewed as a type of forecast, it is almost always an annual process that leads to a comprehensive operating output.  We are strong advocates of forecasting and reforesting throughout the year.  Every quarter is a great routine cadence that can be helpful for management planning, external uses like updating lenders or investors and evaluating what-if scenarios as new opportunities arise.  Some specific examples include:

  • Forecasting higher revenue and payroll to support it if results to date are significantly ahead of budget (or possibly where cuts need to be made if revenue is off the mark)
  • Evaluating new investment opportunities that arise throughout the year and the impact they could have on the overall performance of the business
  • Contemplating payroll changes, such as departmental realignment in the wake of key departures during the year

This forecasting can be essential to provide confidence for management as well as external stakeholders as business evolves during the year.

Maintain Integrity of the Original Budget

Don’t change the budget!  Of course, there can be exceptions like a major error or calculation of a line item, but this is a very slippery slope.  Once a precedent is set, it is way too easy psychologically to manipulate numbers.  Constantly moving goalposts makes management ineffective.  While a company may argue we should adjust the budget because sales are already 25% ahead, what if the flipside were true?  If the company is underperforming and the budget is lowered, all that has done is changed expectations and condoned poorer performance. 

A budget is a critical planning and operational tool for any business.  Regular forecasting is an equally important and complimentary tool.  Both allow management to be better students of the business, improve operational performance and navigate the challenges and opportunities that arise over time.

Small Business Implications to the Tragedy in Ukraine

Two seconds on social media or the television is enough to find heart wrenching images of the assault of democracy in the Ukraine.  Our prayers are with the families and freedom fighters that are standing up to violent aggression in their homeland.  This is a human story, but also has economic consequences for business owners to carefully pay attention to.

Yes, the stock market has been fluctuating wildly. That is one noticeable economic barometer. What underlies this is the potential of growing headwinds to the economy and its small businesses.  Oil prices have skyrocketed, meaning we all pay more at the pump.  But oil is involved in so much more than just fueling our cars.  Air travel could get more expensive, and the cost of shipping goods, which has already dramatically gone up in the last months, could increase even further.  Oil is also a key ingredient in so many products from plastics to packaging.  It almost surely has a bearing on the products you sell. Rising wages may not slow either. Utility costs and commodity prices will also be impacted.  And as this all compounds the inflation problem. 

There has also been talks of additional sanctions. Because of how the global economy is so coupled together, these sanctions could have a double edge sword. Their impact on Europe in particular, which depends on Russia for a significant amount of oil and gas, could cascade indirectly to the United States, creating even more disruption.   

So as a business owner, what do you do? 


1. First, understand the potential risks to your business. Pay close attention to current events and their byproducts, including the price of oil.  New sources cannot be started up overnight, and of course large suppliers like Saudi Arabia could pump more oil into the system thereby lowering oil prices.  But in the short term, the oil markets will be disruptive.  The volatility of oil prices has long been a proverbial canary in the coal mine, so as this continues, business owners should be on high alert. 

2. These are uncertain times, there is no reason to anticipate long term headwinds, but it may make sense to re-assess certain initiatives or growth plans short term. Perhaps even just a pause or tempering of expectations is warranted.  This is unique to each business, but all businesses should at least be asking questions internally on any potential negative impacts. 

3. Don’t operate out of fear. Some businesses owners are just exhausted and even paralyzed after battling Covid, inflation, and now the effect of a war oversees.  Educated, thoughtful action is critical.  The American entrepreneur has survived recessions, the Cold War, and commodity crises to name a few.    Stay strong and re-assure your teams. 

These are sad, troubling times without question.  We must never forget - democracy will win, capitalism will win, and small business will win.  You are the driver of the American dream that countries like Ukraine are fighting so hard to model after. 

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