Tag Archives | production

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Resource waste may take the form of labor or material cost overruns due to poor planning, out-of-date processes or equipment, poor systems design, etc.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.

Pricing for Profit Inspection Guide

Regardless 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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Opportunity Costs

See also:
Opportunity Costs in Your Decision Making
Opportunity Cost Definition

In economics, opportunity costs refer to the value of the next-best alternative use of that resource given limited resources. They are applicable beyond finance and accounting. In daily life, opportunity costs are the benefits or pleasures foregone by choosing one alternative over another.

For instance, if you decide to spend money eating out for dinner in a restaurant, then you forgo the opportunity to eat a home-cooked meal. You also lose the opportunity of spending that money on another purchase. If the next-best alternative to eating out is eating at home, then the opportunity cost of eating out is the money spent. In addition, another opportunity cost is the experience you forgo by not eating a home-cooked meal. In other words, the opportunity cost is the value of the next best use of your resources. When resources are limited, consider the cost between alternatives. Do this so that resources (such as time, money, and energy) are used as efficiently as possible.

Opportunity Costs for Production

Opportunity costs apply to allocating resources in production. In economics, the production possibility frontier (PPF) refers to the point of allocating resources and producing goods and services in the most efficient way possible. If the economy produces quantities of goods below or above the PPF, then infer that resources are being allocated inefficiently. The PPF illustrates that opportunity costs exist when deciding what quantity of goods and services to produce in order to maximize efficiency and production capacity. Companies use opportunity costs in production to make smart decisions by weighing the sacrifices of choosing one alternative over another.

Explicit Costs

Explicit costs are opportunity costs when producers make direct payments for expenses such as salaries and wages of employees, rent and utility expenses, and material costs. For example, a company has a $10,000 rent expense. The opportunity cost of $10,000 could have been spent on other aspects of business operations.

Implicit Costs

Implicit costs are opportunity costs when you use an asset instead of selling or renting the asset to someone else. These opportunity costs exist without any actual payments. Economic profit takes implicit costs into account as an extra opportunity cost when you subtract both explicit and implicit costs from total revenues. Accounting profit only takes explicit costs into account when subtracting explicit costs from total revenues.

Opportunity Costs for Consumption

Opportunity costs apply to allocating resources in consumption. If you decide to spend money on a purchase, then you forgo the opportunity to spend that money on other purchases.

Example

For example, a homeowner decides to use his guest quarters over the garage to create a home office. The opportunity cost of the homeowner’s decision is either:

  • the loss of that guest quarters space for visiting family or friends
  • the potential money earned from renting out the space

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Wage Rate

See Also:
How to compensate sales staff
Compensation Plan
Equity Interest
Capital Project
Damage Claim

Wage Rate Definition

Wage rate, defined as the rate of compensation for a worker, is one of the central themes of the study of human resources. It is determined by 2 factors: productivity at work or number of production hours.

The study of this is known as wage rate economics. It is an important factor to economics because the wages of the average worker form an important factor in both microeconomics and macroeconomics. That is, it effects both buyer behavior and governmental policy.

Wage Rate Explanation

Wage rate, explained as the compensation plan for any employee or set of employees, establishes the cost as well as income of human resources. Explained simply, wage rates are based on the amount produced or the number of hours worked. Sales staff, for example, are given a commission based on the number of sales they make. Conversely, hourly employees are paid a certain amount for each hour they spend at work.

Additional compensation methods exist for employees. Health benefits, medical benefits, bonus’, promotions, and even cafeteria plans amount with the above wages to result in the total wage rate for staff. Fringe benefits, like a company car or free products, are not technically considered part of the wage rate which a worker takes.

Many nations require a minimum amount of income per worker. For wage rate, us government calls this the “minimum wage”. the law requires businesses to pay employees at least this much money in order to continue operations.

Wage Rate Example

Hank is a worker at a major oil company. Hank, a father of 5, works to support his family. He must make a certain amount of income every day to make sure that he can provide for the necessities which his family needs.

Derek, on the other hand, works for the same oil company. As a young and successful man, Derek is looking to optimize his benefit. Derek is looking for a compensation plan that grows with his productivity. Derek is willing to risk something if the gain for success is higher.

Both men are sales staff of the same oil company. Luckily, the company has a “choose-your-own” wage rate determination. They can offer this because of the years of study of their employees and work habits. While one is paid an hourly wage, the other is paid mostly through commissions. This allows each to have the work environment that they want. It proves to be a successful plan: both men achieve the same level of productivity. If meeting with a manager, both men will say that they enjoy their work. It is because of the flexible wage rate decision that each can create the plan that best suits their lifestyle.

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Vertical Integration

See Also:
Horizontal Integration
Business Cycle
Business Segment Reporting
Mergers and Acquisitions (M&A)
Business Intelligence and Finance

Vertical Integration

What does vertical integration mean? Vertical integration is the process or a company’s domination of every aspect of the production line or process for a particular product. This includes the extraction of raw materials to manufacturing, and the sale of the finished product.

Vertical Integration Explained

Vertical Integration was first used in business practice when Andrew Carnegie used this practice to dominate the steel market with his company Carnegie Steel. It allowed him to cut prices and exhuberate his dominance in the market. Currently, this is considered a vertical monopoly and is illegal as an entity.

There are currently three types of vertical integration in the marketplace. The first known as backward integration means that a company possesses control over the first parts of the production process. These can range from raw material possession or production to the manufacturing process. The second form of vertical integration is forward integration where a company maintains control over the forward parts of the production process like distribution and selling of the finished goods. The last of the types of vertical integration is balanced integration. This type of integration contains all parts of the production process, and is also referred to as a vertical monopoly.

Vertical Integration Example

Chris owns a wooden furniture company which is responsible for the manufacture of wooden furniture products to several retailers around the United States. Recently Chris’s company has undergone some strains on its profit margins from the timber companies that supply the company to the retailers who are trying to cut their own costs. Chris has thus decided to vertically integrate to try and enhance his profit margins because if he doesn’t he sees his company going out of business. Thus Chris buys one of the larger retailers so that he can immediately use the large distribution and selling centers around the nation. By doing this Chris can charge a higher price because he is now selling directly to the customer. He can also see a reduced cost for his distribution points.

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Variance Analysis

See Also:
Direct Labor Variance Formulas
Direct Material Variance Formulas
Asset Market Value versus Asset Book Value
Accounting Income vs Economic Income
ProForma Financial Statements

Variance Analysis

Variance analysis measures the differences between expected results and actual results of a production process or other business activity. Measuring and examining variances can help management contain and control costs and improve operational efficiency.

Prior to an accounting period, a budget is made using estimates of material and labor costs and amounts that will be required for the period. After the accounting period, compare the actual material and labor costs and amounts to the estimates to see how accurate the estimates were. The differences between the estimates and the actual results observed at the end of the period are called the variances.

Commonly measured variances include direct labor rate variance, direct labor efficiency variance, direct material price variance, and direct material quantity variance. These variance analyses compare expected results to actual results. The purpose is to see if budget targets were met. Or they see if the operations ended up being more expensive or less costly than originally planned.

Variance Interpretation

Variance analysis will let managers and cost analysts see if the budgeted costs and requirements for an operation accurately forecasted the actual costs and requirements of the operation.

Often, you will find variance between the budgeted requirements and the actual requirements. It is then up to managers and cost analysts to determine if that variance was favorable or unfavorable.

When a variance is favorable, that means that the actual costs and requirements of the operations were less than the expected costs and requirements for the operations. In other words, they expected the production process to cost a certain amount and it ended up costing less. Hence, this is a favorable variance.

When a variance is unfavorable, that means that the actual costs and requirements of the operations were more than the expected costs and requirements for the operations. In other words, they expected the production process to cost a certain amount and it ended up costing more. In conclusion, this is an unfavorable variance.

variance analysis

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Variable Cost

See Also:
How to Prepare a Break Even Analysis
Cheif Financial Officer (CFO)
Cost Accounting
Yield Curves
Financial Ratios
Absorption Cost Accounting

Variable Cost

In accounting, variable costs are costs that vary with production volume or business activity. Variable costs go up when a production company increases output and decrease when the company slows production. These costs may also be called unit-level costs. Variable costs are in contrast to fixed costs, which remain relatively constant regardless of the company’s level of production or business activity. Combined, a company’s fixed costs and variable costs comprise the total cost of production.

In accounting, all costs can be described as either fixed costs or variable costs. Variable costs are inventoriable costs – they are allocated to units of production and recorded in inventory accounts, such as cost of goods sold. Fixed costs, on the other hand, are all costs that are not inventoriable costs. All costs that do not fluctuate directly with production volume are fixed costs. Fixed costs include various indirect costs and fixed manufacturing overhead costs. Variable costs include direct labor, direct materials, and variable overhead.

Variable Cost Example

For example, imagine a company that manufactures widgets. The company has a factory and laborers. The company purchases one unit of raw material for each widget it makes. Each widget requires one hour of labor. Each unit of raw material costs one dollar and each hour of labor costs $10.

This company’s variable costs, according to the example, would be the costs associated with purchasing raw material and the wages paid to laborers. When business is booming, the factory makes 1,000 widgets per day. Therefore, variable costs for raw materials and labor when business is good would be $1,000 for units of raw material and $10,000 for labor wages per day.

When business is slow, the company only makes 500 widgets per day. In this case, the daily raw material costs would be $500 and the daily labor costs would be $5,000. The variable costs associated with production fluctuate with the volume of production. More production volume means more variable costs, and less production volume means less variable costs.

Fixed costs, on the other hand, such as rent and utilities for the factory, remain constant whether the company is producing 1,000 widgets per day or 500 widgets per day. Fixed costs do not fluctuate with production volume.

Variable Costs and Decision-Making

When making production decisions, managers will often consider only the variable costs related with the decision. Since fixed costs will be incurred regardless of the outcome of the decision, those costs are not relevant to the decision. Only costs that will or will not be incurred as a direct result of the decision are considered. And these relevant costs are the variable costs.

If you want to find out more about how to utilize your unit economics to add more value to your organization, then click here to download the Know Your Economics Worksheet.

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Throughput

Throughput Definition

Throughput is the number of units of output a company produces and sells over a period of time. Furthermore, only units sold count towards throughput. Do not count units produced but not sold during the time period as throughput. The goal of a profit-seeking organization is to maximize throughput while minimizing inventory and operating expenses.

For example, let’s take a company that makes guitars. At the beginning of the fiscal period, the company has no guitars in inventory. But over the course of the fiscal period, the company makes 500 guitars. During that same period, they sell 300 guitars. So this company’s throughput for the period would be the 300 guitars produced and sold that period.

Throughput Variables

There is a formula for calculating throughput. Three variables or three components make up the formula. The three variables include the following:

  • Productive capacity
  • Productive processing time
  • Process yield

Productive capacity refers to the total number of units of output that can be produced in a given time period. Whereas, productive processing time refers to the value-added time in the production process. Then value-added time in the production process is time spent increasing the value of the end-product to the consumer. Process yield refers to the percentage of units of output that are of good quality. For example, if a guitar shop produces 100 guitars but three of them are misshapen and unusable, then the process yield for the guitar shop is 97%.

Calculate productive capacity as the total number of units the process can produce divided by the processing time. Then calculate productive processing time as processing time divided by total time available. And calculate process yield as good units produced divided by total units produced.

Throughput Formula

Use the following formula to calculate the number of units of output a company produces and sells over a period of time:

Throughput = Productive Capacity x Productive Processing Time x Process Yield 

Throughput =    Total Units    x    Processing Time    x    Good Units 
      Processing Time      Total Time    Total Units

Enhancement

You can enhance throughput by either increasing productive capacity, decreasing the processing time per unit, and/or increasing the process yield.

throughput

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throughput

See Also:

Theory of Constraints
Supply Chain and Logistics
Depreciation
Total Quality Management
Work in Progress

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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