Measuring the Margins

Corporate profits, according to the Bureau of Economic Analysis, grew by $20.4 billion in the final quarter of 2021, a 0.7 percent increase. For the first quarter of 2022, corporate profits fell by 2.3 percent or $66.4 billion. On an annualized basis, corporate profits fell 5.2 percent in 2022, but grew 25 percent in 2021. With the economy facing inflation, the uncertainty of the Russia/Ukraine conflict, and the world working its way out of the COVID-19 pandemic, economic uncertainty abounds. For companies, measuring margins is one way to evaluate performance and strategize ways to survive and thrive in a dynamic economy. Here are a few common margins that businesses can determine to measure their financial performance.

Operating Margin Defined

Also referred to as return on sales, this measures the profit a business makes on a percentage basis, per dollar, from its core operations. It accounts for manufacturing costs that fluctuate, such as paying employees and input stock. The operating margin is determined by obtaining the business' earnings before interest and taxes (EBIT) and dividing it by its net sales or sales revenue.

Operating Margin = Operating Earnings (EBIT) / Revenue

Operating Earnings = Revenue - (cost of goods sold (COGS) + overhead expenses, except tax and loan servicing costs)

Assuming a business had $10 million in revenue, $1.5 million of COGS and $750,000 in related overhead expenses, it would be as follows:

Operating Earnings = $10 million - ($1.5 million + $750,000) / $10 million

Operating Earnings = $10 million - ($2.25 million) / $10 million

Operating Earnings = $7.75 million / $10 million = 0.775 or 77.5%

Understanding the Operating Margin

This doesn't factor in things such as taxes, interest on loans or other non-core business expenses. However, it gives a picture of what's remaining for its non-core operating expenses, such as servicing outstanding loans. By looking at a company’s past operating margins, the trends can determine a company's performance. Ways to improve the margin include reducing staff redundancy, negotiating better deals on raw materials or reaching more receptive customers.

Marginal Revenue Product (MRP)

If a piece of equipment or employee can create an output of X (the marginal physical product or MPP) and each additional unit of production sells at Z price (marginal revenue or MR), the MRP of the piece of the new investment is MPP x MR. Accepting that all other costs remain constant, if the business owner pays less than or equal to the MRP, it may be profitable. Otherwise, it's not a good decision.

Using the example of a furniture manufacturer looking to respond to increased demand, this illustrates how it can guide business decisions. If a new employee can produce 100 tables every week that will retail for $100 per table, this is the MPP. Based on the calculation, the MPP of 100 multiplied by the marginal revenue (MR) of $100 = $10,000. If the business can hire and retain a new employee for less than $10,000 per week to increase their production by 100 tables per week, it can signal a positive investment.

Marginal Cost of Production

This metric is a way for businesses to determine efficient manufacturing costs. Looking at production volume, this calculation can determine if adding an additional unit to production would add profitability by examining fixed and variable costs. Fixed costs don't change with modifications in production levels.

A static or fixed cost can be spread out over more units of increased production. However, if expanding production capacity requires additional fixed costs, it can add to the marginal cost of production, which will be explained shortly. When it comes to variable costs, as the name implies, as more production occurs, the costs similarly vary.

Assume company A makes widgets with $1 in variable costs and fixed costs of $10,000 per month, producing 5,000 widgets monthly. This would lead to $2 in fixed costs ($10,000 in fixed costs/5,000 widgets).

This final cost per widget comes to $3 ($2 fixed + $1 variable cost).

If company A chose to produce 10,000 widgets a month and they could use existing machinery, employees, etc., their fixed costs would drop to $1 ($10,000 in fixed costs/10,000 widgets).

Assuming the same variable cost of $1 per widget, plus the $1 in fixed costs, it would cost $2 per widget if the 10,000 widgets were produced. However, if additional investments (equipment, etc.) were needed to produce widget 5,001 to 10,000, this consideration would need to be factored in the marginal cost of production. If additional equipment costs $1,000 to increase production, the business would need to factor this in to see if it's still profitable.

Essentially, if this additional production cost is less than the price of an additional individual unit, there's the potential for a profit for the business.

Contribution Margin After Marketing (CMAM)

This measures how much cash is earned from a single unit sold after accounting for promotional and variable expenses. Example expenses include input stock, freight, inventory, etc. It's important to distinguish between pre-planned marketing expenses over a set period of time (per month, quarter, etc.), and variable sales commissions that can fluctuate. CMAM is calculated as follows:

Contribution Margin After Marketing = Sales Revenue - Variable Costs - Marketing Expense

Looking at how much each unit can add to a business' profitability:

CMAM for every Unit = Sales Revenue for every Unit - Variable Expenses for every Unit - Marketing Expense for every Unit

From there, a business' net profit or loss can be found using this ratio:

Net Operating Profit = CMAM - Fixed Costs

Considerations

A smaller or negative CMAM is indicative of a product that's likely uncompetitive. Conversely, a high CMAM, especially over a long time, can indicate the product is well regarded. It can help businesses to determine their most profitable products and/or what products to discontinue, etc.   

With economic uncertainty expected to continue, keeping an eye on past, present and future margins is a key way to maintain a business' chance of thriving in 2022 and beyond.

Sources

https://www.bea.gov/data/income-saving/corporate-profits

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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