A businessman’s view of margin management

I recently had the pleasure of meeting socially with the manager of a large business unit of a listed public company.  As any self-respecting accountant would do immediately after meeting someone new, I invited him to look over my shoulder while I did some work on the Fundable Growth Rate model in GamePlan.  His eyes lit up and he immediately recognized how valuable this type of analytical tool must be for our members’ business clients.   He was so impressed with the FGR application, especially in the current economic climate that I decided to record the conversation we were having so you can get a sense of how business people relate to analytical tools such as this.

Listen to a conversation I had with the manager. It’s a 10 minute chat – 10 minutes well invested as you’ll hear some good advice from someone who thinks just like YOUR clients.

One of the matters that came up in discussion was how the FGR model could be used to graphically show the lunacy of focusing on volume rather than margin in tough times so I gave him a working copy of a small Margin Table application for him to take away and play around with.  A couple of days later he sent me a copy of a memorandum he’d just sent to his management team.

I have reproduced his memo below after removing all confidential data but otherwise what you see is what he wrote — this is precisely the sort of analysis every single one of your business clients need to be having with you today.

Hi Team

Please see an attached spreadsheet called Margin Table that graphically shows the negative effects of discounting our pricing to win work and the profit impact  of gaining 1 or 2 or 3 percentage points of margin operationally or as a pricing strategy.

As a team we have had many discussion over the last few months on the impact of discounting work just to win a job and what that means from a revenue perspective to ensure we achieve our profit target.

By making the decision to invest our capacity (a finite resource) in lower margin work, as you can see from the table, the pressure that puts on us to bring in more revenue is great.  Take our budgeted Gross Profit Margin (GPM) of 25% (currently our YTD is actually GPM 23.5%).  If 2009 pans out as expected and economic times become harder and we find ourselves cutting margins to get work or we continually find ourselves chasing jobs on price and cutting margins as a result of competitive pressure we’re going to be for a really tough time.

For example, say we cut our price by 4 percentage points (to a GPM of 21%), to compensate for this deployment of capacity (overhead) at this lower margin we will need to find an additional 19% of revenue to maintain budgeted profitability (or $X.Xm of additional work over and above our budget revenue).  With work already being hard to get, that’s going to be hard to achieve.

Exactly the same thing will apply from an operational perspective.  For example, if we are loosing 4% on the job due to poor supervision, cost management, poor estimates, etc. the same impact applies.  You can also see that if this goes to 10% as a result of both poor management and soft pricing (say a GPM of 15%), we will need to find an additional 67% of revenue ($XX.Xm) over budget to compensate for this and remain at the same profit level.

As you are all aware, any business has an overhead commitment that can deliver a certain capacity.  In our business our capacity is not determined by machine output BUT people output (administration, supervision, estimating, sales, management, etc) and as such any overhead investment can only deliver a finite capacity before additional costs need to be brought into the business.  As you can see at a 10% erosion of margin any business with our GPM will run out of capacity to deliver the additional 67% of revenue required, assuming it can find the new work, no matter how efficient.  As such this business strategy is an irrational and fruitless exercise.

As with all things, the inverse applies (and remember in business it is far easier to loose money than make it).  If we can gain an extra 2% at the pricing stage or drive it operationally on the job, that means 7% less revenue we will be needed that year (assuming a 25% GPM).  With our revenue target of $XX million an extra 2% means we do not need to find $XXXk worth of work to achieve the same level of profitability.  We all know how hard it is to find $XXXk worth of work, it’s usually easier to get an extra 2% operational improvement or increase in price by selling harder the non price benefits of using our services.

This is even more valuable information for the smaller branches as you will run out of capacity far quicker than the larger business units.

I hope this is useful information and please remember it the next time we are having discussions over margins, pricing your next job and why we cannot let them fall.  I understand that all jobs must be priced on a case by case basis BUT the overall end result must achieve the budget GPM (in our group for this year it is 25% – that is a 33% mark up on cost) and every fraction of a % drop from this makes life very difficult, to the point of becoming impossible.  It will also be a false dawn as everyone will be working hard and feel they and the business are very busy but the end results will not be there financially and this can break morale.

This memo reflects the type of conversation every business advisor should now be having with his or her business clients.  In tough times it is margin rather than volume that’s important.

Too many of your clients are knee-jerking into the wrong actions in a desperate bid to maintain market share and you need to be able to show them the way.