Hiding within gross profit lurks a quiet antagonist. An enemy that many may be secretly unaware of and could potentially be killing their business. That enemy is embedded fixed costs within the Cost of Goods Sold (COGS) line item of the income statement. COGS, frequently also called Cost of Sales, is an important component of any financial report, but it is a subjective measure and its components vary greatly between organizations.
Intuitively one may think that Cost of Goods Sold (COGS) varies in direct proportion to sales. For example, if sales goes up to 10%, COGS should go up a corresponding 10%. In reality, that is rarely the case. The COGS income statement line item may incorporate a series of fixed costs including allocated utility costs, rent, machinery maintenance and other fixed expense that are related to the cost of goods sold but are not variable in nature.
Direct-Basis Income Statement – A Better Way
Subtracting direct variable costs from sales equals Profit Contribution. Profit Contribution minus fixed costs equals pre-tax profits.
- Direct variable costs are those costs that vary directly with sales and production activity.
- Fixed costs are those costs that exist whether an organization has sales or production activity. Fixed costs exist simply because of the passage of time, for example rent.
With Pre-Tax Profits (PTP) being the true measure of a company’s success, it makes sense to create a separate management report outside of the standard Generally Accepted Accounting Standards (GAAP) financial statements presentation to show management a much clearer path as to how the company’s operations are succeeding or failing.
A direct format Income Statement can be easily created by (See Figure 1 for example):
- Separating costs into direct and fixed costs
- Deducting direct variable costs from sales to derive Profit Contribution
- And finally deducting fixed costs from Profit Contribution to get Pre-Tax Profit.
A Direct-Basis Income Statement is ideal as an effective operations management tool and can provide management with a better view of the business to manage costs and improve efficiencies.
Direct-Basis Income Statement – Key Metrics
A Direct-Basis Income Statement allows for the application of several key metrics to be quickly and easily calculated that will help identify areas of operational improvement. Use the direct basis income statement in Figure 1 above and the descriptions of each ratio below as you follow along and calculate each ratio on your own. At the bottom of the section you can check your work.
Return on Labor (ROL)
This metric represents the Profit Contribution earned per dollar of Direct Labor. It provides a useful way to compare the profitability of different products which may be more or less labor intensive. You may wish to discontinue a product line if you are not satisfied with the return being achieved. You can set goals for acceptable ROL performance or even compare your results with those of your competitors or your industry (if the information is available).
Return on Materials (ROM)
This metric represents the Profit Contribution earned per dollar of Material Cost. Here again, it is useful in comparing performance for products having different Bill of Materials requirements.
Return on Prime Costs
This metric simply combines the ROL and the ROM measures.
Breakeven on Labor
This metric essentially measures the ROL that must be achieved to simply cover Fixed Expenses. If we assume that we are getting no ROM, then this metric establishes the minimum ROL required to break even.
Fixed Cost Turnover
This metric measures the number of times that Sales cover Total Fixed Expenses. It is a broad measurement of the turnover of Fixed Costs.
Profit Contribution Margin Percentage
This metric is one of the most useful measures as you will be able to compare Profit Contribution Margins between various SKU’s or Product Lines. It could be instrumental in helping you decide whether to continue producing and selling particular SKU’s or whether to discontinue a Product Line.
Margin of Safety
How many times does Profit Contribution cover Total Fixed Costs? Margin of safety can be calculated multiple ways:
Finally, this metric helps you sleep at night. If your Margin of Safety computes to 1.00, it means that your Profit Contribution is merely covering your Fixed Expenses. If it computes to less than 1.00, it means that your Profit Contribution is not covering your Fixed Expenses. Any number greater than 1.00 indicates that you have a Margin of Safety. Obviously, the greater that number, the better you will sleep.
Example Company Data with Ratios
No Hard and Fast Rules in Finance
Utilizing a Direct Basis Income Statement allows another benefit in regards to financial modeling. Assume that the above numbers are not actual but forecasted sales and expenses. Then they represent only a best guess as to how results may materialize.
The world is filled with uncertainty and any perspective that finance can provide as to how likely it is that a certain scenario will materialize will add a tremendous value to senior management. But how does one do that? Typically, a financial planning and analysis (FP&A) team may put together a sensitivity analysis with a plus or minus 10-20% up and downside scenario to help provide guidance as to potential outcomes of future results. But what if there was a better way? In fact, there is!
Performing a Monte Carlo Simulation
A Monte Carlo simulation is a statistical method that runs a series of scenarios using different variables based on different inputs and their assigned distributions that you designate to ascertain a probabilistic outcome. The first step in the process in running a Monte Carlo simulation is to gather parameters. You might look to your Sales, Marketing and Manufacturing Departments to provide minimum, most likely and maximum values for key model drivers which is what has been done for the sample model and placed in the table below.
In addition to the above parameters, there may be other internal or external events that you would like to consider in the model. In this case, management feels that there is a 30% chance they will add a fixed cost employee on July 1 at an annual salary of $40,000. Using specialty purchased software which works in an Excel® spreadsheet environment, one can input the variables and perform a Monte Carlo simulation which will provide a range of possible outcomes (as well as their likelihood of occurrence) for the newly defined metrics. By reviewing available historical information, one may be able to determine the appropriate probability distributions to replace these uncertain single point estimates.
The output of the Monte Carlo simulation is below.
In the table to the left, we see that Profit Contribution, which was forecasted to be at $555 might be as low as $418 or as high as $635. The mean result, or the average of all the results, is $529 or 4.68% below the forecast. After analyzing the statistics (not shown here), I can tell you that 77% of the results will be lower than the $555 forecast.
You can interpret the other outputs (Pre-Tax Profit, Return on Labor and Margin of Safety) in the same fashion. From the statistical analysis, I can tell you how the results for the other outputs compared to the forecast:
Pre-Tax Profit………………82% of the results will be lower than the $141 forecasted
Return on Labor………….78% of the results will be lower than the 3.08 forecasted
Margin of Safety………….82% of the results will be lower than the 1.34 forecasted
In addition, the analysis of Profit Contribution represented by the following Tornado Chart indicates the sensitivity of the model’s drivers. Other Tornado Charts run for the other outputs displayed the same general findings.
The center line in the chart above represents the mean of Profit Contribution ($528,942). As the simulation is run, the results for each driver are captured. The values to the left of the center line are below the meanwhile the values to the right are above the mean. The wider the variations above and below the mean give tangible evidence as to the sensitivity of each of the drivers. For management purposes, those having greater impacts deserve greater attention.
So, what have we accomplished here? First, we separated all fixed and variable costs such that only variable costs are deducted from sales to arrive at a profit contribution. Fixed costs are deducted from profit contribution to arrive at pretax profit. Second, we created several new metrics that management can use to better manage the business. Return on Labor will enable an evaluation of product or product line profitability based on the intensity of the direct labor component. Margin of Safety will provide a measurement for management to sleep better. Finally, we subjected all of these metrics to a simulation to determine the likelihood that the forecasted results would occur as well as the sensitivity of the drivers.
The only conclusion one can reasonably arrive at is that single point estimate forecasting does not give you the range and depth of insight into your numbers that Monte Carlo simulation does.
What type of scenario analysis do you use in your company? Let me know in the comments below, call or e-mail me below as I am always interested to hear how others are learning and using new forecasting techniques to manage and grow their businesses.