I’ve heard a lot of marketers tell me they want to be more “strategic” and yet I have seen a lot of marketers all too happy to leave the financial math to the finance department and operations. Most marketers are college educated and had to take at least basic accounting courses. It’s worth recalling some of those basics now and to make sure you’re applying marketing with an eye towards where it is most needed and where it will do the most good. And if your duties include product or product line management you’ll want to know which products make sense and which are a drag on profits.
I will not attempt to teach managerial accounting in a blog post. There are a lot of blogs, wikis, textbooks and web sites that can help if you need to review the whole subject. Today I just wanted to use a few concepts as reminders of how we can associate the information from accounting and operations with our marketing decision making. If you work for a manufacturer of multiple real, physical things you are probably better suited to write this than me. If you are blissfully unaware of the basics of cost, contribution margin and things like cost volume profit calculations, read on.
How often have we heard the “we’ll make it up with volume” jokes? Too often in my industry. Yet half or more of the people telling or hearing the jokes don’t actually really know whether the statements are jokes or truths. Cost Volume and Profit are very related but must be taken together. The jokes come from leaving one of the three out, usually cost.
We achieve break-even when our sales exceed our fixed and variable costs. Our products or services are sold in units that have a contribution margin. The units could be hours of labor or boxes of cookies or assembled automobiles. Each contributes a certain amount of gross profit after the variable costs associated with making or providing one more unit. That leftover “profit” isn’t actually profit until we have covered our fixed costs (depreciation on factory and equipment, supervisory salaries, advertising, sales and administrative salaries, etc.) so our break-even (in units) is the result of dividing our fixed costs by our unit contribution margin. With a negative contribution margin, we will never, ever make it up with volume.
The unit contribution margin needed to determine break-even comes from sales price per unit – unit variable costs. The unit variable costs are direct parts that go into each unit or the cost of labor in the case of professional services. In other words, the numbers that go up if you make more units and go down if you make less units. In contract, the fixed costs are those things that do not change whether you make more or less units within a relevant range (ie. you don’t make so many more units that you need to build another factory or buy more machines, etc.).
You can also calculate contribution margin as a ratio (unit contribution margin / unit selling price) which will allow you to calculate your break-even in dollars instead of units by dividing fixed costs by the contribution margin ratio.
With just these numbers and formulas you are equipped to examine the impact on a change in fixed or variable costs on your break-even point but you can go one step further and determine what level of sales is needed to reach your target profit level by simply adding target profit to fixed costs in the break-even formula:
Sales (units) = (Fixed Costs + Target Profit) / Unit Contribution Margin
Now you can get graphical and chart sales vs costs vs profits on a Cost-Volume-Profit Chart or a Profit-Volume Chart. By examining the slope of the lines, whether break-even is ever reached and whether profit grows as volume grows you can find out if you really can make it up with volume or not. Rather than add graphs to this blog post, I’ll refer you to this article from accounting4management.com to see what I’m talking about: http://www.accounting4management.com/cvp_relationship_grahpic_form.htm
I think you can also see how these kinds of charts would be very handy when playing what-if with things like increasing marketing investments, reaching for that next level of volume discounts on parts or even deciding which product lines offer better returns. This last part, comparing product lines can be made easier by extending some of these concepts into sales mix analysis which basically totals the units of multiple products and determines what percentage of units sold come from each product. Unit prices and unit variable costs are averaged based on weight from the proportions of total units which gives you a way to do break-even analysis for the company and know how many of each product are inside the break-even. I’m not going into detail on sales mix today but it is a good concept to read up on.
Where I want to focus is on Operating Leverage:
Operating Leverage = Contribution Margin / Income from Operations
If you know the operating leverage of each of your products you can determine the impact of an increase (or decrease) in sales on each and compare them.
% Change in Income from Operations = % Change in Sales * Operating Leverage
If you find that small improvements in sales result in big improvements in income from operations you will want to focus on how to sell more. If you find that big improvements in sales result in minor improvements in income from operations you will want to focus on how to make manufacturing and or sales and marketing more efficient. One situation is not necessarily better than another as you have to know where the products are in their lifecycle and whether the market is available and receptive to sales efforts you might change or add. Similarly you need to know whether increasing operational efficiency is easily and affordably possible or not.
Depending on your comfort with financial analysis this may have been old hat or a drink from the firehose. My intent is to remind you that not all marketing investments produce the same bottom line result. In fact, a 20% improvement in sales for one product can have a very different effect on Income from Operations than a 20% improvement in sales for another product on an absolute and relative basis. It is to your advantage as a marketer to know what decisions are best and use that knowledge to best sell your plans to your colleagues. Believe me, it is easier when you have the numbers to back up your decisions. And that is one piece of thinking and being more strategic.