FINANCE VIEW

Evaluating ro tability Margins for Products

By Larry White

CMA, CFM, CPA, CGFM

lwhite@rcaininstitute.org

Executive Director, Resource Consumption Accounting Institute (www.rcainstitute.org)

Product profitability is fundamental information, but it is often controversial during internal discussions. Why? External financial reporting calculations are often distorting and the information misleading because they include high-level allocations, flawed depreciation, and miss many product related costs like sales commissions. Decision-relevant profitability information requires clear causal revenue, cost (not just manufacturing costs), and investment (including depreciation/amortization of tangible and intangible assets) information.

Let’s examine some functionality of decisionrelevant information using a quote and margin price calculator (Q&MPC) example. It is part of a resource consumption accounting (RCA) implementation that provides decision makers with causal monetary internal decision support information and enables profitability scenario planning within the relevant range of existing resources. This example focuses on: product contribution margin (CM=price – proportional (variable) costs) and product gross margin (GM=price – proportional costs – fixed costs). In RCA, product proportional and fixed costs reflect strong causal relationships; they exclude generalized allocations. The Q&MPC enables effective profitability management by providing margin-based prices incorporating a forwardlooking stretch target (one standard deviation above the mean) to reduce marginal customers over time and insight into marginally profitable products near breakeven (when fixed costs are covered, all the product’s CM is profit).

The illustration above shows the CM for customers buying Product 13. Costs include all causal product costs including sales commissions and costs for service, support, and warranty. As a result, you see wide variation in the CM by customer. In the system, you can evaluate scenarios such as eliminating outlier customers to make your sample more representative of the customer you are quoting.

This screen shows product profitability components. The CM column examines the impact of price and proportional costs. The green dots will turn red when the price no longer covers the product’s proportional cost. The GM column adds fixed cost impacts, including fixed costs above the product level. For example, if a scenario eliminates the five outlying high CM customers from the first illustration (right side of the graph), the GM and entity margin become negative; but the CM remains positive. This means increased volume at the mean price enables return to a profitable product gross margin and entity margin. In the lower left “price per unit” diagram, price is an outlier for only one customer; therefore, most differences in customer profitability are related to costs. Since this diagram is for one product, the differences result from customer-specific costs and not production-related costs.

Managerial costing systems use causality to improve monetary internal decision support information. They link to manufacturing operations management systems to reflect operational metrics in monetary terms. They link to sales, customer service, and logistics systems to collect information on resource use driven by customer demands for nonmanufacturing support. Incorporating causality leads to better decisions and enables manufacturers to maximize profitability across the organization.

Note: The Q&MPC illustrations are courtesy of Alta Via Consulting (altavia.com). A 20-minute Q&MPC presentation is available at awgo.to/1142.