Why Gross Margin Doesn’t Matter for Manufacturers
Gross margin levels have often served as a critical cost control measurement for manufacturers. However, a manufacturer’s ability to utilize plant capacity has a much larger effect on overall profitability and growth potential. While increasing gross margin is important to monitor and predict, excess capacity can prove to be very costly.
Working within the fixed cost structure
The majority of lower-middle market manufacturers have two resources at their disposal: equipment and labor. The equipment has already been bought and paid for, or is being financed and cannot be flexed up or down during peak times. Additionally, any owner with a skilled labor force cannot afford to lay off employees during down times for fear that they will not be available when business picks up. This mix leaves most companies with a relatively fixed cost structure for direct labor, overhead, and general and administrative expenses.
Breaking the mold with a value-added revenue model
We have seen numerous companies make the mistake of passing on opportunities to utilize capacity simply because they did not comply with their gross margin parameters. What these companies are failing to see is that this “lower margin” work would fit into a period of time or a section of the shop with low utilization (where the equipment or labor has already been bought and paid for), providing for a direct flow to the bottom line. The value-added revenue model challenges this thinking by starting with what the company is earning for the service of converting material, and then breaking that service down into a rate per hour.
For instance, if a company produced 100 widgets, and can sell those widgets for $10 each, it will have top-line revenue of $1,000. If each widget contains $6 of material, the total material costs would be $600. Rather than state that the company had revenues of $1,000, the value-added revenue model would state that the company added $400 of value by converting this material. Once a company can shift its mindset, it becomes much easier to evaluate potential opportunities and their impact on the bottom line.
A good example of this is in metal fabrication. We often see businesses turning down work with higher-costing metals based on gross margin calculations. At first it seems to make sense. If the metal you are working with costs twice as much, but you can only mark it up by the same spread as other materials, then the margin would appear lower.
|Gross Margin vs Value-Add
|Gross Margin Analysis||Widget 1||Widget 2|
|Total cost of goods sold||800||1,700|
|Value-Added Revenue Analysis||Widget 1||Widget 2|
|Value-added revenue %||60%||35%|
|Rate per hour||$50||$75|
However, the script flips when this scenario is placed into the value-added revenue model. When you take out the impact of the material costs (which are not our “value add”) and break down the rate per hour, it makes these types of decisions much easier to make, because it conveys the true financial impact.
In the example, the higher material cost item only produces a 15 percent margin, below the company’s standard 20 percent. However, in the value-added revenue model, the scenario becomes more profitable and the company gets a higher rate of production per hour.
Understand capacity to unlock hidden value
To fully realize this alternative model, manufacturers must explore whether supplementary costs need to be added to the process, or if extra labor would be required to complete the project. But more importantly, the company will need understand its capacity.
The key to unlocking hidden value in a manufacturing company is to understand the overall capacity of the plant, including available equipment and labor hours, as well as the cost structure and the variability of that cost structure.
Now imagine if your investment proposition finds untapped sales channels and your due diligence proves that there is excess capacity on the plant floor. Your business could increase its capacity utilization from 60 to 70 percent and dramatically increase overall profitability, which would have a much larger impact than shaving off a few points in gross margin.
How we can help
It’s easy to get stuck in the gross margin mindset, and there will always be a place for that modeling. However shifting your mindset to a value-added revenue model can lead to better decision making. Our profitability modeling service can help you play out inventory and capacity scenarios, to see if the value-added model can guide you to greater profits.