Making Financial Data More Useful

Relying on standardized financial reporting fails to provide enough detail and insights needed to improve the business.

Our series covering Decision Analysis has provided the framework required to transform generic financial data into an actionable framework. We've covered how to use Unit Economics and Cost-Volume-Profit Analysis to show the profitability of a single unit of product sold and how pricing, costs, and sales volumes affect profits. By using Margin of Safety and Sensitivity Analysis, we know how outcomes will change when our actual results deviate from our assumptions.

These improvements in financial reporting helps decision makers within the business identify potential levers to pull to increase future performance.

How Do We Go About Implementing Improvements?

The problem we face now is how exactly do we go about selecting which options will best increase future performance?

Any changes implemented for improving performance results in questions we must answer. For example, we may identify a specific product or customer who is creating losses for the business, whether due to underpricing or above average costs to produce their orders. How do we go about making changes? Do we implement a price increase on this customer specifically? How likely is it they will accept the price increase? Will they cease doing business with us entirely if we increase prices? If so, will we be able to fill that lost sales volume with new profitable sales? Are we better off even if we aren't able to make up for the lost volume? Does the decline in sales volume free up capacity for pursuing a new product line for our existing customers? How will that affect our overall performance?

It's one thing to highlight these elements on spreadsheets. It's a whole different ball game when it comes to determining the best course of action for improving future performance when we have multiple options to pick from, each with their own potential upsides and risks.

What step-by-step process helps evaluate how each solution affects future performance and how can we determine which ones are riskier compared to others?

5 Step Decision Analysis Framework

I use a 5 step process for evaluating and selecting the options that will increase future financial performance while balancing any potential risks:

1. Establish Unit Economics
2. Evaluate Capacity Constraints
3. What-If Cost-Volume-Profit Analysis
4. Risk Assessment
5. Select and Monitor Results

To illustrate this process, we'll go over a complete example from start to finish.

Scenario Example:

In this scenario, generating sales volume is not our issue.

We're currently operating at full production capacity. We have a growing backlog of customer orders. To improve future performance, we're looking at two options:

1. Increase prices
2. Increase production capacity

Let's run this scenario through the 5 step decision analysis framework to determine the best course of action for increasing profits.

Step 1: Establish Unit Economics

To make our financial data more actionable, we need to use the contribution margin statement format.

This requires adding our relevant sales volume data and reorganizing costs based on their behavior (variable versus fixed) in relation to changes in sales volume. The higher the sales volume, the higher the variable costs, while fixed costs will remain unchanged. Cost of Goods Sold and Selling, General & Administrative Expenses have both variable and fixed cost components. Our two scenarios being examined will cause changes to sales volume. Standard P&L formats will show a distorted view on profits as volume changes while the contribution margin statement format shows a clearer picture. This format will easily show how profits will be affected across each scenario. It also makes it far easier to calculate our unit economics.

Our standard P&L unit economics looks like this:

After reorganizing the data, let's see how our contribution margin statement unit economics compares:

Relying on a standard P&L format may lead us to believe each incremental sale produces $40.00 of additional profits ($40 gross profit per unit). Our contribution margin statement shows the reality is closer to $45.00 of incremental profit per additional unit sold ($45 unit contribution). A difference in $5.00 profit per unit sold can add up, especially when changes in sales volume is a factor.

Our unit economics is currently showing company wide performance. To gain further insights, we can view it by product as shown below:

Step 2: Evaluating Constraints

One element we haven't discussed so far in previous content is the problem of constraints.

In this case, the business is facing a production backlog. We have a limited number of machine hours available to produce a given product. Our problem is a lack of capacity.

At first glance, it may appear that product 1 provides a higher level of profits because it has a $5.33 higher unit contribution. This fails to account for the machine hours required to produce each type of product. We could easily make a mistake that leads to lower profits if we don't view each product based on their unit contribution per machine hour.

We currently have a production capacity of 200 machine hour. Each product type requires a different amount of machine hours to product:

• Product 1: 2.25 machine hours per unit
• Product 2: 1.25 machine hours per unit

By dividing our unit contribution for each product by its relevant machine hours required to produce, we see a different picture as to which provides the most unit contribution:

• Product 1: $20.59 unit contribution per machine hour
• Product 2: $32.80 unit contribution per machine hour

We may find we could increase our marketing spend to fill excess capacity by prioritizing product 2 orders as it has the higher unit contribution per machine hour. This is a key piece of information that will need to be accounted for in our analysis.

Due to our current production constraints, each of our scenarios will affect our sales volume, which in turn may affect the level of production capacity we operate at in the future. Option 1's price increase will likely decrease our sales volume while Option 2's production capacity increase allows us to fulfill more orders. Each will have its own impact on profits.

Step 3: What-If Cost-Volume-Profit Analysis

To gain a full picture, we will be doing two separate CVP analysis for our proposed changes.

Option 1: Increase Product Prices

For this scenario, we need to make some assumptions. After discussing with our sales and marketing team, we make the following assumptions:

• 10% price increase for both products
• 20% decrease in existing sales volume
• 10% increase in new sales volume
• Sales mix remains unchanged

Since we have the same sales mix, the 10% price increase causes our average unit contribution will increase from $45.00 to $55.00. Existing sales volume declines by 20% from 100 units to 80 units and our incremental sales pushes us up to 88 total units. Total contribution margin increases from $4,500 to $4,840 ($55.00 average unit contribution multiplied by 88 units). Profits also increase from $500 to $840 ($4,840 contribution margin minus $4,000 fixed costs), a 68.0% increase. Since our production decreases from 100 to 88, we have 12% unused production capacity (88 units multiplied by average 2 machine hours per unit divided by 200 total machine hour capacity). See the full contribution margin statement below:

We're have a $750 profit target. Let's calculate the sales volume required for breakeven, our current $500 profit level, and our $750 profit target using our new unit economics under this scenario (units rounded up):

We'll use this information in later steps to determine risks associated with achieving our goals.

Let's see how the numbers shake out if we opt to keep our prices unchanged and increase our production capacity from 200 to 250 machine hours.

Option 2: Increase Production Capacity

While increasing prices as seen in Option 1 doesn't require any changes to existing operations, increasing production capacity does. We'll need to add fixed costs in order to increase capacity. After consulting with the production and sales & marketing teams, we've determined the following assumptions:

• $750 fixed cost increase
• 250 new machine hour capacity
• 25% increase in sales volume
• Sales mix remains unchanged

50 hours of additional machine hour capacity from our fixed cost investment results in increasing our production capacity from 100 units to 125 units using the same sales mix we currently have. Our incremental sales pushes us to 124 total units (rounded down to whole units). Total contribution margin increases from our current $4,500 to $5,580 ($45.00 average unit contribution multiplied by 124 units). Profits increase from our current $500 to $830 ($5,580 contribution margin minus $4,750 fixed cost), a 66.0% increase. We're nearly operating at capacity (124 units multiplied by average 2 machine hours per unit = 248 machine hours at 250 machine hour capacity). See the full contribution margin statement for this scenario below:

Let's calculate our sales volume using these new unit economics as we did earlier in option 1 (units rounded up):

We'll use this information in later steps to determine risks associated with achieving our goals.

Step 4: Risk Assessment

We're gaining more understanding what future profits look like under each scenario and the sales volume required to hit breakeven, our current $500 profits, and our $750 profit target.

Our most likely scenario uses a set of assumptions. Now we need to assess the risk associated with these underlying assumptions, specifically surrounding sales volume as that is the biggest unknown in both scenarios.

We can assess the risk for each option using Margin of Safety calculations and Sensitivity Analysis.

Margin of Safety Calculations

Margin of Safety calculations can use highlight the risk associated with how far sales volumes can fall from our plan to either our breakeven point or another sales volume. We'll be assessing the risk of how far sales volumes can fall from plan for both our current $500 profit level and our breakeven point for each scenario.

Option 1: Price Increase

We're planning 88 units in this scenario. Based on our prior calculations, the units required to hit our $500 profits is 82 and breakeven units are 73. Let's calculate our Margin of Safety.

Current $500 Profit Level:

• Margin of Safety = 88 planned units - 82 current $500 profits units = 6 units
• Margin of Safety Ratio = 6 unit Margin of Safety ÷ 88 planned units = 6.8%

Breakeven:

• Margin of Safety = 88 planned units - 73 breakeven units = 15 units
• Margin of Safety Ratio = 15 unit Margin of Safety ÷ 88 planned units = 17.0%

Remember, Margin of Safety Ratio shows how far sales volume can fall below our planned units to hit either our current $500 profit level or our breakeven point. Planned sales volumes can fall 6.8% and we'd remain flat to our $500 current profit level and it can fall 17.0% before we hit our breakeven point.

Option 2: Production Capacity Increase

We're planning 124 units in this scenario. We've already calculated our units to hit our current $500 profits (117), and breakeven units (106). Here's our Margin of Safety calculations:

Current $500 Profit Level:

• Margin of Safety = 124 planned units - 117 current $500 profits units = 7 units
• Margin of Safety Ratio = 7 unit Margin of Safety ÷ 124 planned units = 5.6%

Breakeven:

• Margin of Safety = 124 planned units - 106 breakeven units = 18 units
• Margin of Safety Ratio = 18 unit Margin of Safety ÷ 124 planned units = 14.5%

Our Margin of Safety Ratios for both our current $500 profit level and breakeven point is lower in Option 2's production capacity increase compared to Option 1's price increase.

• Current $500 profit level: 5.6% vs 6.8% Margin of Safety Ratio respectively
• Breakeven Point: 14.5% vs 17.0% Margin of Safety Ratio respectively

This means Option 2's production capacity increase is a higher risk option, albeit by a small amount. Our sales volume does not have much room to fall below our planned expectations before we're back at our current $500 profit level. Both scenarios have Margin of Safety Ratios below 10.0%, which is the range we would expect a good forecast to be within (±10%). We'll want to use Sensitivity Analysis to gain some further insights on risk.

Sensitivity Analysis

±10% is a great range to see how our profits would look like.

Sensitivity Analysis will provide us a table of how profits change under different ranges above or below our planned sales volume. We'll be using increments of ±2.5% (±2.5%, ±5.0%, ±7.5%, ±10.0%) of our planned volume for both scenarios.

Option 1: Price Increase

Our 88 planned sales volume is highlighted in orange.

If sales volume falls below our 6.8% Margin of Safety Ratio as calculated previously, our profits will be lower than our current state ($500) as highlighted in red. Profits between $500 and $750 are highlighted in yellow. Profits greater than or equal to $750 are highlighted in green. As calculated previously, our sales will have to come in at 87+ units in order to meet or exceed our $750 profit target.

Option 2: Production Capacity Increase

Our 124 planned sales volume is highlighted in orange.

If sales volume falls below our 5.6% Margin of Safety Ratio as calculated previously, our profits will be lower than our current state ($500) as highlighted in red. Profits between $500 and $750 are highlighted in yellow. Profits greater than or equal to $750 are highlighted in green. As calculated previously, our sales will have to come in at 123+ units in order to meet or exceed our $750 profit target.

Looking at the two tables, we can see a trend.

• If sales volumes come below our expectations, the price increase in option 1 will result in higher levels of profit over the production capacity increase in option 2.
• If sales volumes exceed our expectations, the opposite is true. The production capacity increase in option 2 results in higher profits than the price increase in option 1 when looking at the same growth rate.

We also know we have machine hour capacity constraints. The upside of an overperformance in sales volume is possible in option 1 as +10% above planned sales volume is 97 units, which puts us under our 200 machine hour capacity (97 units multiplied by average 2 machine hours per unit = 194 machine hours). But we are not able to reap the upside of a sales overperformance above Option 2's plan because even a +2.5% above planned sales volume is 127 units, which is above our 250 machine hour capacity (127 units multiplied by average 2 machine hours per unit = 254 machine hours).

We know that Option 2 is already a higher risk from our Margin of Safety calculations. Adding in our capacity constraints shows us that we aren't even able to enjoy the upside of a sales overperformance vs plan as shown in our Sensitivity Analysis.

Step 5: Select and Monitor Results

We've uncovered a variety of insights so far. Now we need to determine which option makes the most sense for us to pursue.

Let's recap:

I've added the level of profits possible if maximum capacity is reached under both scenarios. Option 1 is $1,500 ($55.00 unit contribution multiplied by 100 units at average of 2 machine hours per unit minus $4,000 fixed costs) and Option 2 is $875 ($45.00 unit contribution multiplied by 125 units at average of 2 machine hours per unit minus $4,750 fixed costs).

Given everything we've gone over so far in our 5 step process, option 1 looks to be the clear winner. It has a lower risk and has more upside potential.

While our sales volume decreases from our current 100 units down to 88 units, the price increase boost total profits from $500 to $840. It also has a higher margin of safety ratio for both our current $500 profit level as well as our breakeven point, meaning it is less risky than Option 2. Due to capacity limits, our unused production capacity in Option 1 leaves room to hit as high as $1,500 (triple our current level). Option 2 on the other hand is capped at $875 as our 124 planned units is single unit short of our production capacity, despite the investment to increase it.

Option 1 also has the benefit of requiring zero changes to operations. Everything remains the same except for the selling price. Option 2 would require additional equipment and hiring of additional employees that will require a ramp up for them to become as productive as our existing employees. This provides an executional risk component that does not exist in Option 1.

Option 1 leaves us with additional options once we see how sales volume is affected by the price increase.

If sales volume decreases as expected, it leaves us the option of increasing our marketing investment (say by $500) if we believe we can fill that 12% unused capacity (24 machine hours) with product 2 sales. If we fill that capacity completely, it increases profits from our planned $840 to $1,290.40 ($49.50 product 2 unit contribution ÷ 1.25 machine hours multiplied by 24 unused machine hours minus $500 additional marketing spend).

There's a real possibility that volume does not drop by as much as we expect (20% existing volume), which would give us even higher profits that we are expecting. If sales volume is unchanged from our current 100 units, we will remain at our 200 machine hour production capacity while tripling our current $500 profit level to $1,500. At this point, we could explore investments that increase production capacity, which can either be filled with additional investment in sales & marketing to increase sales volumes or a new product line.

Given the above information, we will select option 1 and increase prices by 10% across the board. Once implemented, we will need to monitor the results and see if we need to adjust our strategy.

Decision Analysis Framework Recap

We just went through a detailed example on how to utilize unit economics and cost-volume-profit analysis to guide profitable decision making.

Here's a recap of the 5 step process to making profitable decisions:

1. Establish Unit Economics
2. Evaluate Capacity Constraints
3. What-If Cost-Volume-Profit Analysis
4. Risk Assessment
5. Select and Monitor Results

Our next series will cover how to gather a list of options for improving future financial performance. This will center around creating competitive advantages via the Value Advantage, Cost Advantage, and Sales & Marketing Advantage. Each of these have the power to dramatically improve performance, leading to higher profits, cash flow, and the ability to expand and create higher paying jobs for your local community.

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