Standard Financial Statements Are Useless for Decision Making

What worked in the past is not guaranteed to work in the future.

Everything is in constant flux. Selling prices for specific products change. New products are added or dropped. Production costs change as raw materials and conversion costs change. Purchase order volumes change. Your customer base changes over time. Competitors comes and go.

You can run your operations exactly as you have in the past, but experience dramatically different results.

Without the proper financial format, you won't be able to see how changes in pricing, production costs, sales & marketing costs, and sales order volumes will affect profits. A standard P&L format may show you what your past results are, but it hardly is useful for determining what future results may look like.

Without the right format, we will not be able to use our financial data to determine the best path forward to achieve various goals for the business.

Management Financial Formats

Business owners and other key internal decision makers need financial data organized differently than traditional financial statements.

They need to understand how each product, customer, or other segment contributes to the bottom line. Without the right format, many manufacturers will struggle to determine what needs improvement in order to drive future performance. This leads to inefficient pricing on products, cost management, and suboptimal allocation of investments.

We need a tool that allows us to answer critical questions, such as:

• What is the minimum sales volume required to breakeven given your current pricing and cost structure?
• How can we accurately determine the sales volume and revenues required to achieve our profit targets?
• What is the right level of pricing and sales volume for a given purchase order to ensure it maximizes profits?
• Are we better off turning down new business?
• Should we stop producing certain products?
• If we're at production capacity, are there any products or customers that we should address to improve our mix to increase profits?

How can you rearrange your financial data to provide the key insights needed to determine which areas to improve, opportunities to create competitive advantages, and increase overall future performance?

Unlocking the Power of Cost-Volume-Profit Analysis

If you've consumed our last content piece covering unit economics, you know how we can gain far better insights into the profitability of a single unit for as an average across the company, a specific product or customer, or other segmentations.

To recap, this is achieved by grouping costs based on how the behave (variable versus fixed costs) instead of how they are normally classified (Cost of Goods Sold vs Selling, General & Administrative costs). We then divide the relevant revenues and cost behavior groupings by the segment's sales volume to arrive at per unit metrics such as revenue per unit, unit contribution, and profit per unit. Unit contribution is revenues minus variable costs divided by the sales volume. Each additional unit sold can be used to cover fixed costs and the surplus falls to the bottom line as profits.

Unit economics was a key step to formatting financial data in a far more useful view for those working in the business. Now we'll build on those principles by adding Cost-Volume-Profit (CVP) Analysis.

CVP analysis uses the contribution margin P&L format (Revenues minus variable costs = contribution margin. Contribution margin minus fixed costs = profit/loss). This makes it far easier to see how changes to pricing, costs, and sales volume affects total profits. You will be able to determine which products, customers, and other segments are most profitable and which ones need adjustments in order to improve future performance.

CVP analysis enables you to perform breakeven and profit point analysis. Breakeven means determining the sales volume required to cover fixed costs and not lose any money. Profit point gives you the sales volume required to hit a desired level of profits as measured in dollars or profit margin as measured in percentage of revenue.

You can calculate breakeven volume and revenues using unit contribution (Revenue minus variable costs = Contribution Margin. Contribution Margin ÷ Sales Volume = Unit Contribution):

Alternatively, you can use the contribution margin ratio (Contribution Margin ÷ Revenue):

An example is $100 selling price, $50 unit contribution, and $1,000 fixed costs:

Alternatively, we could use contribution margin ratio ($50 unit contribution ÷ $100 selling price = 50%):

We can tweak these formulas to determine the sales volume and revenues required to return a desired level of profit:

Here's an example using $1,000 fixed costs, $500 profit target, $50 unit contribution, and $100 selling price:

If we want to target a desired profit margin, we would use a different variation:

Here's an example using $50 unit contribution, 10% profit margin target, $100 selling price, and $1,000 fixed costs:

Putting Breakeven and Profit Point Analysis Into Practice

Breakeven and profit point analysis can highlight how breakeven sales volume and revenues or profit point sales volume and revenues change when you implement changes to selling price, variable costs per unit, and fixed costs. For example, when unit contribution increases, the sales volume required to breakeven or hit a profit target decreases (and vice versa). This can be accomplished through a reduction in variable costs per unit or an increase in selling price. When the contribution margin ratio increases, breakeven and profit point revenues decrease (and vice versa). Contribution margin ratio increases when the unit contribution as a percentage of selling price increases. There are instances where unit contribution can remain unchanged, but contribution margin ratio increases or decreases. Example:

Here we see we decreased our selling price by $3 and reduced our variable costs per unit by $3 as well. This leaves unit contribution unchanged at $50, but contribution margin ratio increases from 50.0% to 51.5%. This leaves breakeven units unchanged, but decreases breakeven revenues from $2,000 to $1,940.

Knowing this can point to specific strategic decisions to improve performance. When you are approaching or at maximum production capacity, implementing a price increase can reduce sales volume, but the increased selling price may return a higher level of total profits. Here's an example:

Our profit target of $600 at $50 unit contribution and $2,000 fixed cost requires a sales volume of 60, which is 10 more than our 50 unit production capacity. After evaluating our product and customer portfolio, we may implement a higher selling price for a specific customer due to its low profitability and the customer gives us headaches. The customer opts to do business with someone else, but this actually ends up increasing our profits as the selling price was below average and the variable costs to fulfill that customer was higher than our overall customer base's average. Instead of operating at 100% capacity, we operate at 80% capacity (40 sales volume vs 50 production capacity). Despite this decrease in sales volume, we are able to hit our $600 profit target as our revenue per unit increased 10% from $100 to $110 and our variable costs decreased 10% from $50 to $45 per unit. This increased both our unit contribution and contribution margin ratio, which means we can hit our profit target at a lower revenue and sales volume.

Implementing Breakeven and Profit Point Analysis

Breakeven and profit point analysis are important tools enabled by the use of the Cost-Volume-Profit Analysis. Ensure you format your P&L data based on the contribution margin P&L (which groups costs by how they behave) instead of standard P&L formats. This ensures when volumes change, revenues and variable costs also change while fixed costs remain the same.

This analysis allows you to see just how much sales volume and revenues are required to breakeven or hit a desired level of profit for existing and new product lines, customers, other segments, or on a consolidated company wide view. This provides key insights into what contributes the most to the bottom line and what is taking away from it. You now have the data to make performance improvements, whether it's adjusting selling prices, negotiating better supplier prices, improving productivity, or cease producing certain products and fulfilling certain customer orders.

Here's a summary of the step by step process to utilizing CVP analysis in your manufacturing business:

1. Use your unit economics calculated from our previous content. You can start by using a consolidated basis that shows average per unit revenues and costs based on your entire product and customer portfolio. Start with using the last 12 months of P&L data and ensure costs are grouped by behavior (variable versus fixed).
2. Determine your profit target for the time period in the future (e.g. last 12 months of results vs next 12 months).
3. Identify what needs to be true in order to hit your profit target based on your current product and customer base. You may need to break your unit economics down to the product or customer level in order to identify the underperformers.
4. Put together an action plan to either increase the profitability of underperformers and/or free up production capacity to focus on the most profitable products and customers.
5. Implement the proposed changes, monitor results, and adjust when necessary

Breakeven and Profit Point analysis are just a couple of the key tools enabled through the use of CVP analysis.

Our next content will focus on how to use sensitivity analysis and margin of safety calculations in order to determine how far off we can be on our assumptions without going backwards on profits or falling below our breakeven point. This helps quantify any potential risks associated with the options you are pursuing to increase performance.