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Benefits of Using Margin

What Are the Benefits of Using Margin in Pricing?

Do you know your gross margin? What about your profit margin? Your company’s margin indicates whether it is profitable or not. A company can have an extraordinary volume of sales, but without the proper gross margin built into the economics of the company, it results in an unprofitable business.

Start pricing your products or services to result in profit every time. Click here to download our Pricing for Profit Inspection Guide to begin.

The profit margin is the amount that sales (revenue) exceeds costs. So if your profit margin is low, then it may mean that you are making little to no money at all. Setting the correct price on a product or service is the key to profitability. You want it high enough for you to make money, but low enough for products and services to still sell.

Use margin to help you calculate exactly how much you are trying to make per unit, how much you need in order to break even, and most importantly, how efficient the company is.

Margin vs Markup

It is easy to interchange and confuse both terms of “Margin and Markup.” After all, they are remarkably similar. But when it comes to the bottom line, they are recorded and calculated different. Terminology speaking, markup percentage is the percentage difference between the actual cost and the selling price, while gross margin percentage is the percentage difference between the selling price and the profit.

For example, suppose the price of a product is $100, and it costs $80 to make. Both the markup and the margin would be $20. We calculate the profit margin percentage by dividing $20 by the $100 selling price and that equals to 20%. However, we calculate the markup percentage by dividing $20 by the $80 cost and the markup percentage would be equal to 25%.


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It is very important to remember that there are more factors that affect the selling price than merely cost. What the market will bear, or what the customer is willing to pay, will ultimately impact the selling price. The key is to find the price that optimizes profits while maintaining a competitive advantage.

Focus on the Profit Margin

A company’s main focus when it comes to pricing should be based around their profit margin. The margin measures the efficiency of a company when using their labor and raw materials in the production process. The profitability of a company relies on the established profit margin. For this purpose, a company should spend the proper time and effort to calculate the perfect profit margin for their industry and needs.

Pricing for Profit

Discover your company’s perfect price for maximum profitability. As you analyze the benefits of using margin, it’s an opportune time to also take a look at your pricing. Download the free Pricing for Profit Inspection Guide to learn how to price profitably.

Benefits of Using Margin

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Benefits of Using Margin

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Cash Basis vs Accrual Basis Accounting

Cash Basis vs Accrual Basis Accounting

Believe it or not, we deal with this issue of whether to use cash basis vs accrual basis accounting all the time. Many companies start from scratch with one person doing the accounting from home or a small office. Over time, their needs grow. It’s normal to see changes within the organization, especially when companies grow. As you grow, it is critical that you do not neglect the accounting process.

Cash Basis vs Accrual Basis Accounting

What is the difference between cash basis vs accrual basis accounting?

Cash basis accounting is, in its form, the most basic way of tracking your income and expenses based on the actual cash that comes in and goes out every day. Imagine the one employee/owner hot dog stand on the street corner. That business owner goes out early in the morning, pays $2 in cash to the vendor that sells him the hot dog meat and buns. Then, he goes out to the street corner and sells the hot dog for $3 in cash and puts the cash in his pocket. That vendor made $1 profit in cash from the sale of a single hot dog. He sells many hot dogs during the day. This business person is on a cash basis way of tracking his business. In this business owners company there is no difference in timing of transactions between periods.

Moving to Accrual Basis Accounting

If you are bigger than the hot dog stand, then you should probably consider moving to accrual basis accounting for capturing your transactions and accounting. Why? Because we live in an accrual world. Not a cruel world.

If you are reading this blog, then you probably sell a product or service. Most likely, you give your clients terms to pay your invoice. Maybe it is 10 days, 15 days, or even 30 days… But you give your clients time to pay their invoice. You just created accounts receivable (A/R). In the same respect, you purchase things from your vendors – material or services. Likewise, you most likely do not hand your vendor a check or cash that day, but they give you time to pay for the item you just purchased. So, you have accounts payable (A/P). This is probably more realistic. Guess what? You just created accruals.  In this example there are differences in the timing of the actual transaction and when the transaction process if totally complete and settled.  You have to track what is owed to you as an asset, and you have to track who you owe as a liability.

In reality, this is the world we live in and accrual basis accounting is recommended for virtually any business. We live and transact in an accrual environment.

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Accrual Basis Accounting

There are a reasons why major businesses and small successful businesses keep their accounting records on an accrual basis.  One reason is because that is how they generate financial statements that accurately reflect their operations and business, the other is because Generally Accepted Accounting Principals (GAAP) requires companies to be compliant using the accrual basis. A crucial part of the accrual basis is the matching principal – matching revenue and expenses.

You Are 60-90 Days Behind Your Company

The fact is that you are 60 or 90 days behind running your company if you are keeping your books and records on a cash basis. I have actually seen 30-year-old companies with revenues north of $100 million dollars and millions of dollars of expenses on a cash basis. And the recurring comment I get from these business owners is that they have trouble forecasting their business and they think they know what their margins are but really they are not sure. Especially in a business where there is manufacturing or assembly involved, or a service business that is beyond a half dozen people in size, you can bet your margins are wrong if they are on a cash basis.

By not having your accounting records on an accrual basis you are truly 60-90 days behind your business, you are not able to measure or forecast working capital and you will eventually run in to problems.  Some of these problems may be life threatening to your business if there is a downturn in the market or global economy.

It is More Than Margins and Operations

Knowing your margins on an accrual basis and understanding your profit and loss statement is critical. But you also need to know that your balance sheet is correct and truly represents what you have and owe. If you are on a cash basis, then you do not know what you have or owe. For example, prepaid insurance, payroll liabilities, purchase orders entered into your accounting system have not been invoiced by your vendors. As a result, these are all things that will not show up on your balance sheet if you are not keeping your books and records on an accrual basis.

At our firm, we’re are often engaged to help a client company transform their accounting records from cash basis to accrual basis. And the outcome is always positive as management is very happy to know that they can now get good accurate reports and their margins finally make sense. Now they can use their financial statements as one of many tools to run their business.

Cash Basis vs Accrual Basis AccountingA Valuation Perspective On Cash Basis vs Accrual Basis Accounting

You may have a very profitable company on a cash basis, but your financial statements are not going to be accurate. Your company will suffer when it comes down to valuation. Sophisticated financial buyers, strategic buyers and bankers understand that some private companies are still run on a cash basis, but guess what? They are going to discount the value of your company because it is on a cash basis. Eventually, the buyer will want the company they acquire on an accrual basis anyway. This is just another way that you can leave value on the table during a transaction to exit.

Switching from cash basis to accrual basis accounting is just one example of how to protect your company’s value. But there may be other destroyers of value lurking in your company. Don’t let the destroyers take money from you! Access our Top 10 Destroyers of Value whitepaper here.

Tax CPA vs Management CPA

What is ironic is that many Tax CPAs that prepare their clients tax returns or keep books and records do not care if you keep you books on an accrual basis. Actually, if you file cash basis for the IRS and your tax return, it will be easier for your tax preparer to keep your books on cash basis. But that is hurting you from a management perspective. Do not let your tax preparer tell you that you can just as well run your business on cash basis. He or she is simply wrong and too lazy. We can assume that they have never run a business. As a business owner, you need management books/records and management financial statements on an accrual basis and hopefully complaint with GAAP to run your business. They must be kept on an accrual basis so that they are more meaningful as a financial leadership tool.

Remember, CPAs are not all alike. Many of my friends still ask me if I am busy between January and April because I am a CPA. What the heck? I do not even prepare my own tax return, because I am not a Tax CPA.

CPAs are actually very different. The following are some of the different areas CPAs specialize in and many times do not cross other areas:

  • Taxes
  • Audits
  • Management and Operations
  • SEC Reporting
  • Forensic Accounting

Why Not Keep Your Accounting Records On An Accrual Basis?

There is no reason why you would not want to keep your accounting records on an accrual basis. (I am not referring to your tax books and records.) Your operational management financial statements should be kept on an accrual basis. Any decent accountant or controller can help you keep your books and records on an accrual basis. We can also assist you convert from cash basis to accrual basis as we have done this time and time again. We have our process in place to make this as efficient conversion.  In conclusion, there really is no good reason to keep your books and records on cash basis.

To discover other potential destroyers of value, click here to access our free Top 10 Destroyers of Value whitepaper.

Cash Basis vs Accrual Basis Accounting, Moving to Accrual Basis, Cash Basis vs Accrual Basis

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Cash Basis vs Accrual Basis Accounting, Moving to Accrual Basis, Cash Basis vs Accrual Basis

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Should You Use Margin or Markup Percentage for Pricing?

The biggest struggle in maintaining or improving profitability often comes down to pricing.  Two of the most common methods companies use to price their products are margin and markup.  Unfortunately, many people think they’re pricing their products based upon a desired margin, but they’re really using markup.  There is a major difference between the two methods and their impact on your bottom line.

markup percentageThe Problem With Markup

Markup is commonly used to find the price of retail products which are somewhat of a commodity; costs are fixed and the market dictates purchasing price. Let’s explore what happens when you use markup as your primary reference for pricing.

Calculating Markup Percentage

Markup Percentage is the percentage difference between the actual cost and the selling price.

The formula for markup = selling price – cost. 

The formula for markup percentage = markup amount/cost.

Let’s say I owned a t-shirt company, and the unit cost of a t-shirt is $8. I want to sell it for $12. The retail markup would then be $4 because:

Retail markup = selling price – cost = $12 – $8 = $4.

The retail markup percentage is 50%, because

$4/$8 = .50

How Using Markup Can Hurt Your Business in the Long Run

Markup is the difference between the actual cost and the selling price.  Since it is generally market-driven, it often fails to take into account a lot of the indirect costs associated with the product. Setting prices in terms of a particular markup can be dangerous unless the markup has been calculated in a way to consider all product costs – direct and indirect.

Are your sales suffering because of pricing issues?  Check out our Pricing for Profit Inspection Guide to improve your pricing strategies.

Gross Margin Percentage

With our clients, we recommend using gross margin (or profit) percentage for a number of reasons. It is more reliable and accurate, and we can easily see the impact on the bottom line.

Calculating Margin

As mentioned before, gross margin is:

Sales – Cost of Goods Sold (COGS). 

We then find the gross margin percentage, which is:

(Gross Margin/Sales Price) X 100.

Based on these calculations, how do we determine the selling price given a desired gross margin? It’s all in the inverse (of the gross margin formula, that is). By simply dividing the cost of the product or service by the inverse of the gross margin equation, you will arrive at the selling price needed to achieve the desired gross margin percentage.

Margin Percentage Example

For example, Steve charges a 20% markup on all projects for his computer and software company which specializes in office setup. Steve has just taken a job with a company that wants to set up a large office space. The total cost needed to set up the space with computer and the respective software is $18,000. With a markup of 20% the selling price will be $21,600 (see how to calculate markup above). The margin percentage can be calculated as follows:

Margin Percentage = (21,600 – 18,000)/21,600 = 16.67%

Margin vs Markup

As you can see from the above example, a 20% markup will not yield a 20% marginFailing to understand the difference between the financial impact of using margin vs. markup to set prices can lead to serious financial consequences.  In the example above, if Steve were to assume his 20% markup would yield a 20% margin, his net income would actually be 3.3% less than expected. While a 3.3% difference in net income may not seem like much, to many low-profit-margin businesses it can mean the difference between solvency or bankruptcy.

Additionally, using margin to set your prices makes it easier to predict profitability.  Using markup, you cannot target the bottom line effectively because it does not include all the costs associated with making that product.

How to Minimize Margin vs Markup Mistakes

Margin vs Markup Chart

15% Markup = 13.0% Gross Profit
20% Markup = 16.7% Gross Profit
25% Markup = 20.0% Gross Profit
30% Markup = 23.0% Gross Profit
33.3% Markup = 25.0% Gross Profit
40% Markup = 28.6% Gross Profit
43% Markup = 30.0% Gross Profit
50% Markup = 33.0% Gross Profit
75% Markup = 42.9% Gross Profit
100% Markup = 50.0% Gross Profit

Conclusion

To sum things up,  markup percentage is the percentage difference between the actual cost and the selling price, while gross margin percentage is the percentage difference between the selling price and the profit. Markup is not as effective as gross margin when it comes to pricing your product.  Not only should you take into account how much it costs to acquire the product, but you also need to take into account the indirect costs associated with your product in order to ensure you’re selling your products at a price that will result in profit.

If you’re still uncertain about how to price your product or service to be profitable, download the free Pricing For Profit Inspection Guide. This ultimate guide allows you to easily discover whether you have a pricing problem and gives you steps to fix it.

markup or margin

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Adjusted EBITDA

See Also:
EBITDA Valuation
Calculate EBITDA
Valuation Methods
EBITDA Definition
Multiple of Earnings

Adjusted EBITDA Definition

Adjusted EBITDA is a valuable tool used to analyze businesses for the purposes of valuation and potential acquisition. Many also call it Normalized EBITDA because it systematizes cash flow and deducts irregularities and deviations. Use adjusted EBITDA as an additive measure to determine how much cash a company may produce annually and is typically used by security analysts and investors when evaluating a business’s overall income; however, it is important to note business valuation using Adjusted EBITDA is not a Generally Accepted Accounting Principles standard. As a result, do not uses it out of context as various companies may categorize income and expense divisions differently.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization and is a meaningful measure of operating performance as it allows businesses and investors to more fully evaluate productivity, efficiency, and return on capital, without factoring in the impact of interest rates, asset base, tax expenses, and other operating costs.

Adjusted EBITDA is a useful way to compare companies across and within an industry. Many consider it a more accurate reflection of the company’s worth as it adjusts for and negates one-time costs such as lawsuits, startup or development expenses, or professional fees that are not recurring, just to name a few. More importantly, adjusting EBITDA often reflects in a higher sale’s price for the owner.

Adjusted EBITDA Margin Calculation

Adjusting EBITDA measures the operating cash flow using information acquired from income statements. Measure it annually. But when you average it over a three to five year period in order to account and adjust for any anomalies, it is most beneficial. Generally speaking, a higher normalized EBITDA margin is preferred, and the larger a company’s gross revenue, the more valuable this new measurement will be in a future acquisition.


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Typically, analysts will then normalize or adjust the standard EBITDA by considering other expenses outside the operating budget. Adjusted EBITDA is found by calculating the Net Income, minus Total Other Income (Expense), plus Income Taxes, Depreciation and Amortization, and non-cash charges for stock compensation.

At this point, you are probably curious how to calculate Adjusted EBITDA. The following is a simplified example of how you might begin calculating this formula for your business. Start with EBITDA; then add back value to your company by considering areas of excess and factoring in one-time costs.

Screen Shot 2016-06-08 at 9.24.05 AM

Differences between EBITDA versus Adjusted EBITDA

EBITDA and Adjusted EBITDA have a few key differences. EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, identifies a company’s financial profits by calculating the Revenue minus Expenses (excluding interest, tax, depreciation and amortization). It compares profitability while excluding the impact of many financial and accounting decisions. The EBITDA margin is an assessment of a company’s operating profitability as a percentage of its total revenue. Calculating the EBITDA margin allows analysts and investors to compare companies of different sizes in different industries because it formulates operating profit as a percentage of revenue.

Adjusted EBITDA, on the other hand, indicates “top line” earnings before deducting interest, tax, depreciation and amortization. It normalizes income, standardizes cash flow, and eliminates abnormalities often making it easier to compare multiple businesses. Examples of when you need to account adjustments while evaluating the value of a company for a buyer include:

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Adjusted EBITDA

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Adjusted EBITDA

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Margin Compression

money in a viseEver heard the term “margin compression”?  Put simply, margin compression occurs when the costs to make a product or deliver a service rise faster than the sales price of the product or service.  Hence, putting pressure on profit margins.

Causes of Margin Compression

There may be many causes of margin compression…

  • Increased competition
  • Internal production problems
  • Macroeconomic factors
  • Rising SG&A costs without a proportional increase in price

Increased Competition

When I started The Strategic CFO over 16 years ago, I remember how hard it was to sell the idea of a part-time CFO.  Nobody was doing it, so it was tough to convince people that there was a need.

These days, there are so many new companies providing interim CFO services that trade show sponsors struggle to separate our booths in the exhibit hall.

As you might expect, the influx of new firms offering the same services as SCFO put pressure on our margins.  One of the ways that we have responded is by developing alternative income streams.  As a result, we now offer additional services complementary to consulting that aren’t yet so competitive.

 Internal Production Problems

Sometimes, a business can put pressure on itself.  Internal problems such as not using resources wisely can cause a business to incur more costs than necessary.

Resource waste may take the form of labor or material cost overruns due to poor planning, out-of-date processes or equipment, poor systems design, etc.  Regardless of the source, it’s important for businesses to monitor and improve key drivers in order to ensure that all resources are as productive as possible.

Macroeconomic Factors

Unless you’ve been living under a rock, you’re probably aware that low oil prices are wreaking havoc on much of the energy industry, as well as many tertiary industries.  While it may seem like there’s little a business can do to deal with such macroeconomic factors, there’s still hope.

Even though it’s tempting to be reactionary in the face of crisis, focusing on the long-term goals of the company rather than the short-term obstacles is critical.  Yes, you should closely examine costs and cut those that aren’t mission-critical.  It’s important to realize, however, that the crisis will end and you must still have the necessary resources to take advantage of the recovery.  The best antidote for these “black swans” is to plan for the crisis before it’s upon you.

SG&A Costs Out of Whack With Pricing

How do you price your products or services?  Some companies apply a markup to their direct costs.  Others set their prices to achieve a desired margin.  Very few, however, take their pricing down to the net income level.

While it may seem heavy-handed, examining all costs that go into making a product or delivering a service is necessary.  Otherwise, it’s easy to ignore creeping SG&A costs and their impact on profitability.  To guarantee that you’re pricing for profit, make sure that your pricing model takes into account SG&A costs.

Think you might have a pricing problem?  Download our free Pricing for Profit Inspection Guide here.

Margin compression

Margin compressionRegardless of what is causing your margin compression, there is a solution.  Diversification, improving productivity, planning for lean times and pricing for profit are just a few ways to deal with the problem.

How have you dealt with margin pressure?  Leave us a comment below with you thoughts.

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Segment Margin Example

See also:
Segment Margin
Margin vs Markup
Prepare a Breakeven Analysis
Budgeting 101: Creating Successful Budgets
Cost Volume Profit Definition
Variable vs Fixed Costs

Segment Margin Example

Segment Margin is important to a company because, most obviously, companies make profits off of their services and products. To acquire revenue from these services and products, a company would use a segment margin in order to determine whether the product has enough economical worth to continue producing. Therefore, it makes sense to provide an example so that segment margin can be viewed in a real life situation. An segment margin example is provided below.

Example And Explanation of Segment Margin

A shoe company, Fastbrink Shoes, has many different lines of shoe products and memorabilia that they sell to the public in order to make a profit. Because there are so many products, Fastbrink decides that they are going to trim down the number of products so that the most profitable and marketable products are getting the most attention. At the same time, they also want to eliminate the products that do not earn as much revenue as the more popular models and products. In one such case, Fastbrink has a line of basketball shoes that comes in two different colors, blue and black. Fastbrink wants to decide which shoe to keep and which shoe to scrap. Fastbrink will do this by calculating the segment margin for each shoe to determine which is the more profitable.

Segment Margin Calculation

It must be noted, first of all, that segment margin is calculated by taking the segment revenue of a product. This is essentially the revenue that is produced by a single product by itself. You then subtract the variable costs from the segment revenue and finally subtract the total avoidable fixed costs from that number to decipher the segment margin of a product. For this situation, the segment revenue for the blue shoe is $40,000 for the quarter while the revenues for the black shoe total $35,000. The variable costs for the blue and black shoes are $13,000 and $10,000 respectively. Finally, the avoidable fixed cost for both shoes is $10,000 for labor, parts, and machine maintenance. When calculated completely, the segment margin for the blue shoe comes out to be $17,000. Whereas, the black shoe segment margin totals $15,000.

Because the blue shoe rakes in $2,000 dollars more revenue that the black shoe, Fastbrink decides to discontinue the black shoe. As a result, profits on the blue shoe (more profitable model) can be maximized.

If you want to learn how to shape your economics to result in profit, then click here to download the Know Your Economics Worksheet.

segment margin example

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Segment Margin

See Also:
Segment Margin Example
Segmenting Customers for Profit
Net Profit Margin Analysis
Operating Profit Margin Ratio
Margin vs Markup
Profitability Index Method

Segment Margin Definition

Segment margin is a measure of profitability that applies to individual product lines. It is calculated as segment revenues minus variable costs minus avoidable fixed costs. It is also used to measure the profitability of a segment or product line when you make the decision of whether to continue or discontinue that segment or product line.

Segment Margin Calculation

Use the following formula to calculate segment margin:

SM = Segment Revenues – Variable Costs – Avoidable Fixed Costs

Segment Margin and Decision-Making

Segment margin separates relevant costs from irrelevant costs when analyzing a product line. For instance, if management is deciding whether to continue or discontinue a product line, the appropriate calculation for measuring the relevant revenues and relevant expenses for the decision would be to use this type of margin.

The difference between segment margin and other measures of profitability, such as contribution margin, is that it divides fixed costs into three categories. Consider one of the categories of fixed costs relevant when making decisions about the segment in question; the other two categories of fixed costs are irrelevant.

Segment Margin and Fixed Costs

The three categories include the following: avoidable fixed costs, unavoidable fixed costs, and common expenses. Avoidable fixed costs are relevant in the decision-making process of whether to continue or discontinue a product line. Whereas, unavoidable fixed costs and common expenses are irrelevant for decisions regarding a particular product line.

Avoidable fixed costs are those fixed costs that would not incur if you eliminated the segment or product line. Unavoidable fixed costs are fixed costs necessary for the continuation of the segment or product line. But those fixed costs would still incur if you discontinued that segment or product line. Eliminating the segment in question would merely cause the allocation of these unavoidable fixed costs to another segment. Refer to common expenses as expenses incurred by the company as a whole that are allocated to various segments or product lines.

If you want to increase the value of your organization, then click here to download the Know Your Economics Worksheet.

segment margin

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segment margin

Source:

Barfield, Jesse T., Michael R. Kinney, Cecily A. Raiborn. “Cost Accounting Traditions and Innovations,” West Publishing Company, St. Paul, MN, 1994.

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