When I started my career as a management consultant, I thought that the whole solution was sales. Increase the revenues would make problems disappear. Of course, my simplified view of business was quickly confronted with the reality of manufacturing.

So on my first business rightsizing in 1990, true to my beliefs, my primary mission was to increase sales to avoid my client bankruptcy. When making the diagnosis, and following a reorganization of the GL accounts on the income statement, I was amazed to see that the more product the company produced and sold, the more money they were losing. The factory making doorframes and jointed pine moldings had a higher cost of goods sold than the value of the sales, showing a negative gross margin.

The analysis of the job cost identified helped identified issues and correction. With annual sales of $1.5 million, the company should have had a maximum of 15 employees assigned to the production, but it had 27. The quality of the raw material used was inadequate. Pine boards of grade 4 and 5 were used instead of grade 2 or better. Consequently, sometimes managers preferred to burn the finished product instead of shipping it to customers. Wood and glue, believe me, makes for a great campfire!

The changes were positive. By reducing manufacturing costs, the new gross margin was now positive. This new situation helped to focus on developing sales, which increased by 100% annually, from $1,5 million to $3 million. In this case, the development of sales could not have been successful without a marked improvement in gross margin.

Gross profit shows the productivity of operations. The more efficient the company gets, the faster it can reach breakeven. To calculate the breakeven point, take the fixed costs of the company and divide it by the gross margin percentage.

For example, if your company has fixed costs of $1 million and gross margin is 25%, the breakeven point is $4 million.

 

Breakeven =    Fixed costs / Gross margin %   =    $1 million / 0,25  =  $4 million

This means that for sales of $4 million, gross margin will be $1 million, which amount must be subtracted from the $1 million of fixed cost, for net income of $0. This is the breakeven. So, for each dollar of sales exceeding $4 million, net income will be $0,25. Therefore, sales of $5 million will give a net profit of $250 000. (($5 million – $4 million) x $0,25)

 

What if the gross profit margin is less or greater than 25%? For the same example, with fixed costs of $1 million, if the gross margin is 10% this means that the breakeven point will be $10 million.

 

Breakeven =     Fixed costs / Gross margin %    =    $1 million  / 0,10  =  $10 million

 

So, before you start making a profit of $0,10 per dollar sold, the company will have to make minimum sales of $10 million.

The opposite, if the gross profit margin is 40%, the breakeven point will be reached much more rapidly with sales of $2,5 million ($1 million / 0,40), then providing a profit of $0,40 for each dollar sales exceed the breakeven point.

 

Breakeven =     Fixed costs / Gross margin %   =    $1 million / 0,40  =  $2,5 million

 

Healthy operations and production management is a guarantee of success for the manufacturing company. The number of variables and the speed at which the company must react requires integrated management system that captures information at the point of production. The component costs and the time value of labor must be entered immediately in order to check at the beginning of a trend, changes in the job cost.

Proper use of technology included in an Enterprise Resource Planning system (ERP) allows the identification and verification of the actual operating costs, which could then be compared to the expected results and highlight any differences.  The causes of theses differences might be: fluctuation in currency exchange rate that would have an impact on price of raw materials or the routing time allocated vs actuals time spent producing. The information collected should allow the manager to make the necessary adjustments as quickly as possible.

The ultimate goal is always to increase gross margin that in turn will allow the company to reach breakeven in a shorter amount of time and to generate maximum profits for every dollar sold.

 

 

Richard Landry, b.b.a., m.b.a.
www.visionmanagement.ca

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