Key Considerations When Evaluating Your Manufacturing and Distribution Company’s Profitability
Are owners and members of senior management at manufacturing and distribution companies paying close enough to their business’ profitability? Not necessarily of the overall company’s gross profit, but more granular pieces and line items that help comprise their business profit. Many are surprised to find what is driving overall profitability once they dig deeper into their company’s financial details. This article will highlight some key items business leaders should consider when evaluating their company’s profitability.
For most companies, not all of their customers are the same. Whether it be purchasing power, logistics, allowance incentives, or other variables, pricing amongst customers can vary greatly. As companies struggle to retain their workforce and do more with less, understanding the profitability by customer is an important metric to evaluate. Consider the following scenario:
If the decision is made to cease operations with Customer E, revenue comes down 4,000 dollars and gross profit comes down by 320 dollars, however, margins are up two and a half percent. This may not seem like a lot in a small scenario such as this, but all factors should be considered. Of the four customers, Customer E has one of the highest volumes of business yet contributed the least to the bottom line. As we will discuss further below, this likely is not the full cost of serving this customer. Important questions to consider are:
- What are the sales commissions on the 4,000 dollars and how do those eat into the eight percent profit margin?
- How much labor cost is getting allocated to pick and pack or manufacture products for Customer E?
- Can that time be better dedicated to servicing the four other customers or bringing in a new customer?
It is important to note that the example in Table 1 does not even consider any potential added costs that may be required to servicing each of these customers. For instance, if Customer A requires their goods to be shipped, whereas Customer C picks up the product from your warehouse, although the initial gross margin appears more favorable for Customer A doing the same volume of sales, when considering other cost factors such as shipping, the margins might be tighter.
Product Profitability,p>A significant portion of challenges faced by manufacturing and distribution companies today are related to current disruptions with the supply chain. While senior management seeks to effectively operate despite frustrations such as managing inventory levels and delayed lead times, it is no secret that supply chain disruptions can most adversely impact the cost of products. While the increase in shipping and logistics costs are extremely high and greatly affect cash flow, companies may not be considering these costs as it relates to its individual product offerings.
In addition, some senior leaders are not considering other costs. For lightly manufactured products, labor and overhead should be properly evaluated. With the cost of labor increasing, standard costs need to be evaluated consistently to ensure they are capturing the true cost of the product.
Consider the following example:
Table 2 shows profitability of Products A-E when only considering cost of the product itself.
Table 3 illustrates the effect to gross profit when you incorporate labor/overhead and other potential costs to the product.
As you can see, when evaluating profitability by product, it is important to consider all relevant costs. Although many Enterprise Resource Planning (ERP) systems provide for a labor and overhead allocation through standard costing, it is important to revisit standard costs periodically to ensure the absorption is appropriate.
Lastly, when evaluating low profitable products, it is important to understand its impact on total product offerings and expectations of your buyers. For example, if a customer buys Products A, C, and E from you, consideration has to be given before eliminating Product E as to whether or not that customer will move all of its purchases to a new supplier if you no longer offer that one product.
Moving Forward to Better Profitability Insights for Your Business
When evaluating profitability, it is important to thoroughly consider all factors in determining true cost of the products. When speaking with senior leaders, one of the main reasons profitability is not tracked at the product or customer level is due to limitations within their accounting system, however, with the many benefits of understanding profitability and what drives it, it may be a worthwhile investment that can pay dividends long term. As many business leaders are speculating that customers are going to start pushing back on price increases as we head into what some consider a recession, managing costs becomes a prevalent and important concern. If you do not have an ERP system or accounting team capabilities to perform this function on your own, please reach out to a Citrin Cooperman professional today.
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