The True Cost of Ignorance

Every decision made by manufacturers can have dire consequences on short and long term profitability and cash flow.

Most of these decisions are made without understanding the true financial implications. This results in costly mistakes. For example, Incremental sales volume does not always produce linear incremental revenues and costs. This is because the business environment is dynamic, not static. Incremental costs can increase at a far higher rate than incremental revenues.

There are a variety of reasons for this.

We may need additional overtime or machinery in order to fulfill the newly added sales volume. In this case, the incremental costs for the additional volume can far outweigh the incremental revenue from the order. Other times, the incremental cost to produce additional volume is far lower than what our current results would lead us to believe. The true incremental costs to produce additional volume can lead to drastically different acceptable bidding prices for a new purchase order.

So how can manufacturers gain the crucial financial insights they need to make profitable decisions?

Marginal Analysis as Your Management Guide

We need a tool that accounts for the dynamic nature of costs as they don't always behave linearly with changes in volume.

Marginal analysis is used to guide decision makers to determine how incremental benefits compare to incremental costs for a variety of decisions.

We'll cover 3 different examples of decisions that use marginal analysis to show their true financial impact:

• Make-or-Buy
• Special One-Time Orders
• Sell or Further Process

Each of these requires identifying what information is and is not relevant to the decision at hand, as well as capturing the incremental benefit or cost associated with the given decision.

Make-or-Buy Decisions: Calculating Your Maximum Outsourcing Price

This type of decision is to determine whether we are better off producing something in-house or if we should instead outsource it.

We need to identify all relevant costs, both variable and avoidable fixed costs, as well as any opportunity costs. Opportunity costs are the forgone benefit by pursuing one option over another. We want to know the most amount we would be willing to pay to have a given product or function outsourced. To accomplish this, we would use the following formula:

Let's use this in an example with the following information:

• Volume: 100 units
• Internal Production Costs: $50 variable costs per unit + $3,500 fixed costs
• Unavoidable Costs: $2,000 fixed costs

Based on this information, our total internal production costs are $8,500 ($50 variable costs per unit multiplied by 100 units + $3,500 fixed costs) and our unavoidable costs are $2,000. Below shows the maximum price we would be willing to pay:

At 100 units, the most we would be willing to pay to outsource production is $65 per unit ($6,500 maximum price willing to pay ÷ 100 units). We would have higher profits by producing this product in-house if we were unable to get the purchase price below $65 per unit.

When faced with decisions such as make-or-buy, we must also consider any income or cost savings that result from the alternative use of resources currently in use by the business.

For example, outsourcing products with low contribution margin may free up the production capacity needed to produce higher contribution margin products. The low contribution margin products are still needed by our existing customers, so we outsource it to retain those customers while freeing up capacity to produce higher contribution margin products. This increases total profits.

Here at Productive Powers, our goal is to increase the productive capacity of United States manufacturers. With this in mind, outsourcing decisions should be contingent on a few requirements:

• No employee layoffs should result from outsourcing
• Any outsourcing should be limited to manufacturers producing the actual parts (not just assembling) in the USA

We need to increase the productivity and skills of Americans. This can only be done if we focus on doing business with fellow U.S. manufacturers when necessary. Even when a product or function is outsourced to fellow U.S. companies, the goal should be to increase the skills of our workforce and increase our production capacity so we can manufacture and produce as much as possible in-house.

The main reasons to outsource production are as follows:

• Free up production capacity to focus on the most profitable products
• Internal skillset or machinery limitations
• Strategy customer value add-on
• Special one-time orders

Strategic outsourcing can free up capacity to focus on manufacturing more profitable products that increase the company's bottom line. There could also be some temporary skill gaps where the team's current capabilities are outside of what is required for a given order, which can be bridged by outsourcing. Customer value add-ons could be made possible using an outsourced partner to assemble products as the whole is greater than the sum of its parts. Special one-time orders or products with unique specifications requiring machinery we don't have on hand can be fulfilled using outsourced vendors. Outsourcing production to fellow U.S. companies can be highly profitable if you focus on assembly. This is similar to how the aerospace industry operates by contracting out a large portion of production to various partners and then assembling them in-house.

There are always tradeoffs from outsourcing production.

You lose control over a variety of things, such as speed of service, level of customer support, and more. These are not as obvious when looking only at the differences in costs between producing in-house versus outsourcing. Nevertheless, they create real value for customers which results in superior performance. All decisions to outsource must account for this.

Special Order Decisions: The Minimum Acceptable Price for New Business

For special order decisions, we want to determine what the minimum price we would be willing to accept.

We'll need to identify the direct or avoidable costs of producing the special order. These are usually variable costs. Fixed costs typically are unchanged whether or not the special order is accepted and thus are irrelevant to the decision.

The company's current production capacity should also be considered. If the company is operating below capacity, special orders can boost profits with low selling prices as long as it provides positive contribution margin. If it is operating at capacity, existing production must be scaled down to make room for the special order. The contribution margin for the special order may require the selling price to be greater than the existing production forgone.

Let's go over examples for both, starting with operating under production capacity.

Operating Below Capacity

Here's the relevant information for this scenario:

• We're currently operating at 70% of our production capacity
• Special order volume: 200 units
• Special order variable costs per unit: $70
• No incremental fixed costs are required for the special order

If we were to accept the special order, we would still be under our production capacity. With no incremental fixed costs required, any selling price above $70 would increase our profits as it provides positive contribution margin.

But that doesn't mean we should simply bid something as low as $71 per unit.

All modeling and forecasts within ±10% are considered good. If we apply this to our estimated $70 variable costs per unit, we may have costs per unit come in as high as $77. This means we need to place a bid higher than $77. Also, we should factor in market prices for producing such an order. If the market price is closer to $100, we would want to bid somewhere in between, say around $90 per unit as the discounted price is attractive enough to win the bid.

Operating At Capacity

Now let's see how the same special order would impact profits if we were operating at capacity:

• We're currently operating at 100% of our production capacity
• Special order volume: 200 units
• Special order variable costs per unit: $70
• No incremental fixed costs are required for the special order

Here's our current production for product A's financials for operating at capacity:

We would have to decrease our Product A's production volume by 200 to accept the special order. This represents $10,000 contribution margin ($50 unit contribution multiplied by 200 units). Since our special order variable cost estimate is $70 per unit, we would require a minimum selling price of $120 per unit in order to offset the decrease in contribution margin from producing less of Product A ($70 variable cost per unit estimate + $50 unit contribution = $120 selling price).

But as we've noted, variable costs could potentially skew upwards towards the $77 per unit range, putting our target selling price closer to $127 per unit. On top of this, it doesn't make sense for us to accept the order if our profits were the same as what our current operations produces. We would want to see total contribution margin increase as a result of accepting the order. A selling price of $140 or more may be what we require to make it worth our time. If the market price was closer to $100 per unit, we would not be able to win a bid for this order as anything lower than $140 would not increase profits above current levels.

Our production capacity level has dramatic effects on the selling price we would require to produce the same customer order.

There are also qualitative factors to consider.

Existing customers can become upset if you delay their orders in favor of fulfilling a special order. An existing customer may be providing negative contribution margin, which a special order gives you the flexibility to implement a price increase to see if you can either turn that customer profitable with a higher selling price, or profits can be improved by having that customer leave and backfilling their production with the special order.

More often than not, there is no benefit from producing a special one-time order when operating at capacity unless you have existing customers with negative contribution margin. You'll only risk pissing off your existing customers, which creates downward pressure on long term profits.

Sell or Process Further: Maximizing Profit

Sell or further processing decisions require analyzing whether it is more profitable to sell products as is, or to incur additional costs to further process them into products with higher contribution margin levels.

As an example, a dairy plant processes whole milk into cream and skim milk. At this point, they can choose to sell the cream and skim milk, or further process them into butter (further processing cream) and/or yogurt (further processing skim milk).

To determine what is most profitable, we have to isolate the relevant costs and revenues with this decision.

Processing whole milk into more than one product using the same production process is called joint production processing. Joint production costs are the costs incurred during this process and the costs cannot be isolated to one product over the other. Eventually, a split off point occurs where the individual costs to process each product can be measured. All costs up to this point are joint costs that are shared between all products. Costs after this point are assigned to the individual products.

For our analysis, joint costs are irrelevant.

This would be the costs incurred to turn the whole milk into cream and skim milk. They cannot be changed no matter what our decision ultimately is. What is relevant to our analysis is the additional costs we would incur by further processing the cream into butter and the skim milk into yogurt. We can choose not to incur these costs if we choose to sell the cream and/or skim milk without further processing.

The next step is to compare the contribution margin of the cream and/or skim milk versus the contribution margin of the butter and/or yogurt, assuming we have no difference in fixed costs. Here's how it looks:

We can see the further processing of cream into butter produces a lower contribution margin than just selling the cream as is. But for skim milk, the further processing into yogurt produces a higher contribution margin. It would be most profitable to sell the cream as is and further process all skim milk into yogurt.

This assumes we can sell the entire production run for the given mix.

We may not be able to do so. It can be more profitable to further process some portion of the cream into butter, even though it has a lower contribution margin. Failing to do so may leave us with unsold cream that results in spoilage and lost revenue, which can lead to a lower level of contribution margin compared to selling some combination of cream and butter. The same goes for yogurt. We may be better off processing only a portion of the skim milk to ensure we are able to sell everything we produce to minimize spoilage and maximize profits.

Marginal analysis helps manufacturers determine whether the incremental benefit outweighs the incremental costs when faced with a variety of decisions.

Our next series will be taking a look at pricing strategies to help manufacturers increase their profits by understanding potential impacts to sales volumes with pricing changes.

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