Organizational Performance Part 45: Understanding Margin and Profit | Operational Excellence Quick Hits
Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to understanding margin and profit. We hope you enjoy the information presented!
In today’s session, we’re going to continue on the mindset change necessary to achieve breakthrough improvement in companies. Today’s session is going to be on Understanding Margin and Profitability. The mindset that I see in many companies is in order to increase profitability, we need to increase the margin on the product. And how do we increase the margin, it’s by reducing cost. So I want to challenge that assumption and look at it from a different perspective.
So I want to look at cost volume profit analysis, and it’s a managerial technique that’s concerned about the effect of sales volume on product cost and operating profit of a business. And it deals with how changes in cost can affect the margin and how it can affect the profit for the company. So I want to look at a couple examples. So the basic formula for the cost volume profit is that price times the volume is equal to the variable cost, times the volume plus the fixed cost plus profit.
And in this case, I’m going to challenge this variable cost because what I see in many companies, as long as the operating within the relevant range, there’s very few costs that are variable in the short term. Many costs are fixed in the short term. The only costs that we see that are variable in the short term, are what we call the totally variable cost. So those are the costs that increase as a result of producing one more unit. I’ve only seen four totally variable costs. First is material cost, if you have to buy material, it goes into your product. Second is outside services. So if you send products out to a subcontractor to do work. Third is sales commissions, and fourth is freight if your company pays the freight. If we look at this formula, the price times the totally variable cost volume, plus the fixed cost plus a profit.
And what we want to do is we want to look at a breakeven analysis. So in this breakeven analysis, we have our costs on the left hand side and our volume along the horizontal axis. And we have fixed costs of 150,000 and our totally variable costs are 40%. So if you look at this, you can see the green line represents our revenue based on volume. The blue line represents our fixed costs. The red line represents our totally variable cost. So in this case, the breakeven point is at $250,000 at 50,000 units sold, so our breakeven cost is $5. So anything above $5, we’re going to make a profit, assuming that we can sell 50,000 units.
Now, if we look at it from a different perspective and we’re not changing our fixed cost, but we’re changing our totally variable cost. So if you see in this graph compared to the graph in the previous one, as the total variable cost percentage decreases, the slope of this line decreases. So the lower the slope of this line, the more leverage the company has. If the slope was steeper, of course, it’s going to be the break evens much further out into the number of units sold. So one of the things I look at in organizations is what’s the totally variable cost as a percent of total cost, and we’ll understand the slope of this line. Again, the more level that line, the more leverage there is within the organization.
So if I take this model and I look at the margin, so the margin is the selling price minus the total cost, in this case, we’re selling it for $6. So our margin on the product is $1 because our break even cost is $5 and we’re selling it for six. So what’s that in terms of percents? We just take the one divided by the cost of 5 times 100%, so our margin is 20%. So therefore in order to increase margin, we must either one, increase the price or reduce the total cost.
So now let’s look at the impact of improvement. So I’ve taken this data and I’ve put it into a table, looking at the volume, revenue, totally variable cost, fixed cost and profit. So the first one here is we have a selling price of $6 and a totally variable cost of 25%. And 50,000 units sold, our profit is 87,500. Now, if I reduce our cost by 10%, our fixed costs go from 150 to 135, our totally variable costs don’t change, so our profit goes up to 102,500, so a net change of 15,000. So a 15% reduction goes right to profit. What happens if we improve flow by 10%, instead of reducing cost by 10%? You see our profit goes up at a much faster rate.
Now I look at a 20% reduction in fixed costs. Again, that 30,000 goes right to the bottom line in terms of a net change, but what’s a 20% improvement in flow? That goes to 47,5. So what this tells us is reduction in cost act in a linear manner, improvements in flow act in an exponential manner. So what does that mean?
So if I look at the impact on profit on improvements, if I look at cost reduction, this line as I get percentage of improvement, has a linear effect on profit. If we look at improvement and from a flow perspective, the flow has a exponential improvement on profit. So the leverage is improving flow, not reducing cost. And also when we look at cost reduction, the greater the percentage of cost reduction, the more difficult it is to achieve it. So a 5% cost reduction might be fairly easy to have obtained, a 25% cost reduction is a massive undertaking. But from a flow perspective, if we understand flow and what’s controlling the flow, to get a 25% improvement in flow, is not that difficult to do if you understand your system. The leverage is improving flow and the opportunity is improving flow, not reducing cost.
So that’s our session for today. Next week’s session, we’re going to be talking about Waste Reduction and the mindset of waste reduction as a primary means to improve company performance.