How well are the components of profit margin truly understood? Without a more granular understanding of margin by region, division, sales channel product category, customer or product, companies will struggle to make best informed decisions.
In the latest of our making best informed decisions series, Oliver Bridge explores some of the ways you can understand the true profitability of your commercial and operational activity.
Business leaders are now focused more than ever on sustaining and increasing margins in a very dynamic environment disrupted by multiple macro and micro factors. Over the last two years, we've worked with a wide range of organisations to help them get to the bottom of 'what makes money, why and how'. Very often, this begins with going 'back to basics' – including understanding the definition of margin.
What is a margin?
If we boil it down to basics, margin consists of three main components:
- Cost
- Price
- Volume (product) or utilisation (services and assets)
While often companies looking to improve margin will target cost reduction as a first port of call, this should be done with caution and not without a full understanding of the impact on the quality of product or service being delivered. For example, it's easy to look at a bucket of cost, say customer service, in isolation without fully understanding the value they may bring to each sales channel. As a result, a blanket reduction in this cost could directly compromise quality of a particular channel and have a disproportionate impact on volumes or utilisation, which in turn may offset the margin improvement generated from the cost saving.
Similarly, an increase in price can be difficult to justify to your customer base, particularly if not matched by an obvious increase in the value of the product/service proposition. Again, a blanket rise in prices across product base without understanding the complex price demand characteristics of each product or service type, could cause a shortfall in demand, and again offset the margin improvement generated from the cost saving.
Furthermore, taking a blanket approach to cost cutting and price increases ignores the unique characteristics of a product or service in its stage of the lifecycle. For example, it may be more effective to remove an entire underperforming product range or sales channel and the associated cost, with limited impact on the rest of the business.
Getting a granular understanding of your margins
True visibility on your margins can minimise the risk of cost saving or price increases to your business. These are some actions you can take:
1 Understand your management accounts and remove any unwanted ‘noise’ – anything that has happened in the financial period you do not expect to continue, or adjustments made for accounting/tax purposes.
2 Decide and define what level you would like to understand margin. For a manufacturing business, this may be to understand how efficiently and cost effective a particular process or product is. For a retail business, this is more likely to be around the performance of a particular sales channel.
3 Understand the unique cost and revenue drivers for your business. Investigate what data is available in your business to support the quantification of drivers. This may include:
- operational data such as material usage, production volumes or labour utilisation
- commercial data such as pricing strategies, discounts and rebate structures.
Overlaying financial data that's traceable back to the profit and loss statement (P&L) on this data develops a cost mindset within the business and in turn will enable better decision making.
4 As well as the more direct costs in the business, understanding how your central functions support the revenue streams, customers or product types you have identified. For example, is the finance function too caught up in solving PO issues for 'X' client that they have no time for strategic planning?
5 Once you have collected suitable data, it's important to work out how you will continue gathering it in a sustainable and repeatable manner, using automated outputs from systems where possible to give you real-time insights.
6 Build a long-term reusable data model to allow for short and long term decision making that will help you identify where to target cost, price, volume or utilisation factors at a more granular level.
This all sounds very theoretical, so let us help with a real-life example from our client base….
How we helped a client
A large Tier 1 automotive supplier engaged us to review the profitability of their existing product portfolio which was failing collectively to hit required margin targets. The company had a very good understanding of the top-level margin but needed us to conduct additional analysis at product category and product level. Our work for them:
- recognised that the approach to quotations and pricing was out of date and did not allow for a controlled and managed approach to price changes with OEMs
- discovered volatility in the raw material cost was being recovered at around a six-month delay putting pressure on cash flows
- identified that complexity of some products on certain manufacturing processes was not reflected in the costing of the specific product category. Processes were put in place to capture the additional cost associated with these products
- discovered that volume shortfalls across the business was causing a knock-on effect on transport and subcontracting costs at a unit level and unfairly penalising customers who had been meeting target volumes
- highlighted that indirect costs were allocated evenly across products and customers even though they largely related to a small number of SKUs and specific customers. Amending the allocation method for indirect costs improved the pricing of contracts immediately.
In this case, getting that understanding at a product and customer level allowed targeted negotiation with the right customer with robust supporting data that stood up to scrutiny.
So, whatever your current challenge may be around understanding margin at a granular level, asking these key questions about your products, profits and costs is the first step in a proven approach that links relevant commercial and operational improvements to the P&L. Such rigorous analysis might feel uncomfortable to start with, but this level of directness is what you need to improve your business performance.
For support in asking the right questions and understanding regarding your profitability, get in touch with Oliver Bridge.
