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.