Evaluating Profitability Margins for Products

Product profitability is fundamental information, but it is often filled with controversy during internal discussions. Why? The calculations acceptable to external financial reporting are often distorting and the information misleading because they are composed of high-level allocations, flawed depreciation, and miss many product related costs like sales commissions. Decision-relevant profitability information requires clear and causal revenue, cost (often not just manufacturing costs), and investment (including depreciation/amortization of tangible and intangible assets) information.

Let’s examine some functionality of decision-relevant information using a quote and margin price calculator (Q&MPC) example. The Q&MPC is part of a resource consumption accounting (RCA) implementation that provides decision makers with causal financial internal decision support information and enables scenario planning to manage margins and profitability within the relevant range of existing resources. This example focuses on two important pieces of information: product contribution margin (CM=price – proportional (variable) costs) and product gross margin (GM=price – proportional costs – fixed costs). In RCA, product proportional and product fixed costs reflect strong causal relationships; they exclude generalized allocations. The Q&MPC enables effective margin management by providing:

1. Margin-based information that causally reflects an organization’s operations
2. Margin-based prices incorporating a forward-looking stretch target (+ standard deviation above the mean) to reduce marginal customers over time
3. Insight into product and customer profitability
4. Insight into marginally profitable products that could contribute significantly more to profit based on their proximity to breakeven (i.e., when fixed costs are covered and all the product’s CM is profit)    

This screen allows examination of key components of product profitability. In the CM column, the impact of price and proportional costs are examined. The green traffic light incorporates the dead-loss point (it turns red when the price no longer covers the product’s proportional cost). In the GM column fixed cost impacts are added, including fixed costs above the product level. These are reflected in a hurdle rate added to the entity margin. For example, if a manager wants to see the impact of losing the five outlying customers from the first illustration with high CMs (the right of the graph), the GM and entity margin become negative; but the CM is still positive. This means you could increase volume at the mean price and return to a profitable product gross margin and entity margin. Notice in the lower right “price per unit” diagram that price is an outlier for only one customer; so most of the differences in customer profitability are related to costs.  Since this diagram is for one product, the differences result from customer-specific costs and not production-related costs.

This is only one example of the type of analyses supported by managerial costing systems that focus on causality to improve monetary internal decision support information. Managerial costing systems build on operational systems such as manufacturing operations management systems whenever possible to reflect operational metrics in monetary terms. They also include links to sales, customer service, and logistics systems to collect information on resource use driven by customer demands for non-manufacturing support. The incorporation of causality will lead to better decisions and enable a manufacturer to maximize profitability across the organization.

Note: The Q&MPC illustrations are courtesy of Alta Via Consulting (altavia.com). A 20 minute Q&MPC presentation is available: https://youtu.be/UWAUZw3PY44 .

Larry White, CMA, CFM, CPA, CGFM, [email protected], is Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org) which trains and advocates for improved cost information connecting operations to business performance.