~Situation Analysis~

Company Situation: Financials

Margins:

> (%) Contribution Margin  = Sales - variable costs (Direct Labor + Direct Materials + Inventory Carry) / Sales

> Net Margin: Period costs (Depreciation, Sales General & Administration costs which include R&D, Promotion... ) are subtracted from the contribution margin to determine the net margin

> ROS is defined as (Net Profit / Total Sales). ROS looks at the entire company's after tax margins

<Why do margins matter?>

Why focus upon Contribution Margin, Net Margin, and Return On Sales? To simplify things, let's consider an example where you have only one product—

Contribution Margin is defined as Sales less Variable Costs. Variable Costs are the expenses that are tied to the sale of each unit. They are recognized when a unit is sold. Because the number of units you sell varies with demand, they are called Variable Costs. In the example above you sold 1 million units. If you had sold 2 million, your Variable Costs would have been $38 million, but if you sold 500 thousand, they would be only $9.5 million.

In short, you do not know your Variable Costs until the sales numbers arrive.

Period Costs, on the other hand, are not tied to sales. In the example above, you spent $5.2 million on Period Costs whether you sold anything or not. While you could not say what your Variable Costs were until December 31st, the Period Costs were known on January 1st.

Net Margin is defined as Contribution Margin less Period Costs. Put simply, it is what the product contributes towards profits.

From the combined Net Margin (normally across all products) you pay the expenses that cannot be allocated to a product. First comes "Other" (expenses like brokerage fees), then Interest, Taxes, and Profit Sharing until you are left with a Net Profit.

<What is critical here?>

Have another look at the example. Notice that all the expenses from the PERIOD COSTS label down are either fixed or a percentage of profits. The moment you submit your decisions, everything but Profit Sharing and Taxes is known, and they only occur if you produce a profit. Those known expenses total ($5,200 + $100 + $2,500 = $7,800) or $7.8 million. If your Contribution Margin cannot cover $7.8 million, you are destroying wealth instead of creating it.

In the big picture, you cannot have a decent ROS unless your Net Margin Percentage is good, and you cannot have a good Net Margin Percentage unless your Contribution Margin Percentage is healthy. In Capstone^®'s industry, this translates to a 10% ROS, 20% Net Margin, and 30% Contribution Margin.

 

<3 Key Considerations>

Consider your detailed Income Statement in your Annual Report. Typically, some of your products are producing healthy margins, while others are slim to negative. Your task is to improve the margins on the poor performers. Are Period Costs too high? Are Sales, and therefore the Contribution Margin, too low?

1. If your ROS is below 5%, but your Net Margin Percentage is above 20%, you either experienced some extraordinary "Other" expense like a write-off on plant you sold, or you are paying too much Interest (If TQM is enabled, you may also have spent heavily on TQM initiatives).
2. If your Net Margin Percentage is below 20%, but Contribution Margin is above 30%, the problem is heavy expenditures on Depreciation (perhaps you have idle plant) or on SGA (perhaps you are pushing into diminishing returns on your Promo and Sales Budgets).
3. If your Contribution Margin is below 30%, the problem can be traced to some combination of Marketing (customers hate your products), Production (your labor and material costs are too high), or Pricing (you cut the price too much).

Profits

The Profit category examines the rate at which wealth is being created.

 Where margins look at percentages, this category examines the actual value of the profit. Because the industry is growing, the profit required to earn 100 points increases each year.

For example, if this is Year 1, and your Net Profit is $3 million, you earned $3M/$6M or 50 points. Of course, negative profits earn no points.