The Problem With Standardized Financial Statements

Staring at generic Profit & Loss (P&L) Statement formats will not provide the detail required to improve the business.

This format lacks key data points, such as sales volume, which is required to calculate unit economics. This format shows the profit or loss associated with a single unit of product, whether as an average across all products sold during that period, a specific product, or even an average for a single customer. Without this data point, you will not have an understanding how different levers (pricing, costs, and volume) affect profits.

Some products or customers will only be profitable with large purchase orders. But those large purchase orders often put downward pressure on selling prices, which reduces profitability. If you're operating without an understanding of your unit economics, pricing decisions will be based on gut feelings. These gut feelings may actually create losses as the costs to produce are higher than the associated revenues. Other orders could be less profitable than they could be as the business may be under pricing those orders. Each of these scenarios produces suboptimal profits.

Unit economics is a prerequisite for utilizing Cost-Volume-Profit (CVP) analysis. These two formats work together to provide actionable data your manufacturing business can use to create competitive advantages, which in turn increases future financial performance.

Financial Statements Built For External Users

Most manufacturers with annual revenues under $15.0 million have minimal resources in their accounting function.

They may have an in-house bookkeeper, accountant, or they may just outsource the entire process to an outside vendor. These people are concerned about organizing financial information in a way that is more useful to external decision makers (creditors and investors) as opposed to being optimized for internal decision makers (owners and managers).

This isn't their fault. They are simply complying with reporting requirements. But financial statements for external decision makers help them compare many different businesses across a wide range of industries. This requires making generic financial statements that aren't actually helpful for those working in the business.

Without financial data organized specifically for internal decision makers, we will not have the detail required to improve the business. Profits will be suboptimal as we won't be able to adjust pricing to ensure it covers our costs to fulfill purchase orders while being price competitive with other manufacturers. We will lose out on higher levels of profit as we won't know how best to allocate our limit production capacity to specific products that maximize profits. We won't know whether we should actually turn down business because it is actually more profitable to operate at a lower production volume until we improve our production processes to handle higher volumes.

These insights are impossible to see using standardized financial reporting.

How can we take the current generic financial data manufacturers typically receive and transform it into a format that provides decision makers with the tools required to increase future financial performance?

The Decision Maker's Financial Statement

We start by taking the data from our current generic financial statements and creating a new format to use for unit economics.

Contribution Margin Statement

This new P&L format is called a contribution margin statement.

This format groups costs by their behavior (variable costs vs fixed costs). This makes it far easier when we later use this information in CVP analysis to determine how changes in pricing, costs, and sales volume affects profits. Using this format is crucial for developing strategies to create and increase competitive advantages, which are the only way to improve performance.

The standard P&L format is as follows:

Both COGS and SG&A have variable and fixed costs within them. Variable costs change in total as the level of activity changes (e.g. the higher the sales volume, the higher the variable costs). Fixed costs on the other hand do not change within their relevant range. A relevant range means the cost does not change over a specific range of volume. For fixed costs, this could be anything between zero units and the total facilities or specific production equipment's maximum production capacity. Any sales volume above this capacity threshold would require additional fixed costs to fulfill, while sales volume between zero and capacity will have the fixed costs remain the same.

COGS has variable costs such as direct labor hours. As sales volume increases, so does direct labor hours, which in turn increases total variable costs. It also has fixed costs, such as a specific piece of equipment used in the production process, which would remain unchanged as long as volume is within its relevant range.

SG&A has variable costs such as advertising or commissions for sales reps. As sales volume increases, so do these variable costs. At the same time, the salaries for sales reps would not change as sales volume change as it is a fixed costs.

The contribution margin P&L format splits the variable and fixed cost components and groups them as individual buckets. The statement format is as follows:

Unit Economics

We can take the information from the contribution margin P&L to calculate our unit economics by pulling in the relevant sales volume. To do this, we take each section (revenue, variable costs, contribution margin, fixed costs, and profit/loss) and divide by the sales volume.

Let's use the following as an example:

We can see our unit economics is as follows:

• Revenue Per Unit: $100.00
• Variable Costs Per Unit: $50.00
• Unit Contribution: $50.00
• Fixed Costs Per Unit: $35.00
• Profit Per Unit: $15.00

A standard P&L format may lead us to believe 100 additional units gives us $1,500 incremental profit ($15.00 profit per unit multiplied by 100 additional units). But since we have variable costs separated from fixed costs, we can easily see the true incremental profit from 100 additional units sold is actually $5,000 ($50.00 unit contribution multiplied by 100 additional units).

In order to achieve that incremental volume, we need specific actions. One path may be to increase our marketing spend. We would be more than willing to increase our marketing spend by $2,500 to get $5,000 back, increasing total profits by $2,500. A standardized P&L format would tell us this is not a profitable move as spending an additional $2,500 would only return $1,500 back, decreasing profits by $1,000.

The way financial data is presented can lead to drastically different decision making.

Unit economics provides much better information for decision makers. We can use this view to look at the per unit metrics for different product categories, customers, proposed purchase orders, and more to gain insights as to which of these are contributing to increased profits and which are creating losses. It can inform pricing decisions, as well as highlight the need for increased productivity to drive down costs to become more profitable. Some products and customers should be given priority over others while some should be discontinued altogether if we aren't able to increase prices or decrease costs per unit. This helps free up capacity to focus on the most profitable products and customers. Those increased profits can be invested to create additional capacity or create competitive advantages to ensure long term superior financial performance.

Action Steps:

Begin organizing your financial data into the contribution margin statement to calculate your unit economics. Below is a summary of steps to begin implementing this in your business:

1. Identify the segment for unit economics. Start with company wide performance, then work your way down to the product and/or customer level.
2. Reorganize costs based on their behavior (variable versus fixed) instead of the standard P&L COGS and SG&A format
3. Formulate your contribution margin statement (revenues minus variable costs = contribution margin; contribution margin minus fixed costs = profit/loss)
4. Layer in the relevant sales volume and calculate your per unit metrics
5. Compare the results for products and customer against others. How do they stack up? Which ones are contributing most to your bottom line and which ones may actually be creating losses?

Our next content piece will focus on how to use unit economics in CVP analysis. This will show the business what levers it can pull to best increase future performance.