By: Lori Adams
Last week I attended the National Tooling and Machining Association Emerging Leader Conference. As I spent time at the conference, I realized there was one underlying question most of the owners were asking: how can I improve my profitability? This is an important question to say the least, as profitability is what often defines a company’s success.
Simply put, there are 3 ways to improve profitability – understanding costs, understanding capacity, and understanding pricing. The one that will have the greatest impact on profitability is understanding capacity.
Capacity is generally not given as much attention as pricing and costs are. At the conference I must have heard over 30 times – “I do not know how much time it takes to build the product.” A response like that indirectly implies: _I do not have any idea what my capacity is on any given resource at any given time. _ In order to improve profitability, it is necessary to understand the contribution margin and determine the capacity for the shop floor. Contribution margin is Total Revenue less Material Costs less Outside Service Costs. Once you know the contribution margin, you can predict what the value per hour any additional sales will contribute to the profitability. Then, once you determine which resources have idle capacity, the challenge exists to offer products to best utilize that capacity.
Contribution margin is different than gross margin. Far too often, I hear people discuss the gross margin and base their estimates on gross margin. When you look at gross margin, labor is assumed as a variable cost. However, this is not the case as labor is really a fixed cost. It is important to alter the estimating methodology to adjust for that fact in the short-term.
Exhibit 1: 10% Increase in Utilization, 28% increase in Profit Scenario A Scenario B Hours Available 1000 1000 Hours Utilized 800 900 Utilization 80% 90% Sales $10,000.00 $11,250.00 Variable/unit $5,500.00 $6,187.50 Contribution Margin $4,500.00 $5,062.50 Fixed Costs $2,500.00 $2,500.00 Profit $2,000.00 $2,562.50
Exhibit 1 demonstrates a change in methodology of looking at contribution margin instead of profit margin. It also shows that for a 100-hour improvement in capacity utilization can greatly improve the profitability. This analysis shows that a 10-point improvement in capacity can drive a 28% increase in profit.
Therefore, when trying to improve profitability in the company, it is important to understand which resources are being underutilized and to then push products that will use those resources.
When creating a quoting & estimating methodology, it is imperative to look at future business from a contribution margin perspective in order to generate sales based on the capacity available. This will allow for great profit.
For more information regarding contribution margin and how it can improve profitability, please contact LillyWorks at www.www.lillyworks.com.