Does Your Income Statement Tell You the Truth?
Our previous article on “Three Steps to Predictable Financial Results” outlined a control, profitability, growth philosophy. A business needs to be under control and understand how and where it makes money before it grows. When these steps are taken out of order, we frequently see serious unintended consequences of significant financial losses. In this article we’ll explore predictable profitability.
Most middle market CEOs know if their overall business is making or losing money. However, very few understand the underlying profitability of their company. Most of our client’s income statements are improperly structured since they have not looked effectively at the profitability of their products/services. Sadly, most of our turnaround clients fit this profile.
Let’s look at Company A and B below to help illustrate the importance of underlying product profitability.
The totals for Company A and B are identical in every respect. They both sell 25,000 units, have sales of $150,000, etc. However, their underlying product profitability, i.e., their contribution margins, are as different as day and night.
To understand how to utilize this data to make better decisions, we’ll explain three concepts.
The definition and implications of Contribution Margin.
The difference between quantity and quality of financial results.
Why averages lie.
Contribution margin equals sales minus variable costs. Your contribution margin is the most important indicator of underlying profitability because it tells you how much money you make (or lose) on each item you sell. Contrary to popular belief, if a product and/or service has a negative contribution margin, you can’t “make it up on volume.” The opposite is true! The more you sell, the more money you will lose!
Next, both the quantity and quality of your financial results matter. Quantity represents absolute dollar amounts whereas Quality represents the underlying metrics. In our example above, the quantity of financial results includes sales units, sales and contribution margin. By comparison, the quality of financial results includes sales/unit and contribution margin/unit. Quality indicators provide priceless insights that allow you to understand relative profitability and critical trends.
For example, Company A may want to sell more of Product 2 because it has higher quantity indicators than Product 1. However, one unit of Product 1 generates almost two times the amount of profit ($3.25 vs. $1.83). All else being equal, the company is much better off growing Product 1!
Finally, averages lie. Both companies total financial results are identical from a quantity and quality perspective. In fact, if Company A was the industry benchmark, Company B would think they’re doing great. Right? WRONG!
Company B has serious problems with Product 1’s contribution margin! Even though their overall contribution margin/unit averages $2.40, identical to Company A, the average is masking a significant loss on Product 1. If Company B stopped selling Product 1, their profit would immediately increase 25%!
To ensure your company is financially healthy, monitor each of your product’s and/or service’s contribution margin, focus on quantity and quality of financial results, and don’t be misled by averages.