Manufacturers: Are you Evaluating the Right Profit Metrics?

Profitability is a critical metric for any business. Recent supply chain disruptions, labor shortages, and demand fluctuations have wreaked havoc on many manufacturing businesses, causing an increased need for leaders to understand profitability at a detailed level. Some manufacturers have struggled to manage skyrocketing costs and are uncertain how to best pass cost increases to their customers. Leaders struggling with these decisions may consider evaluating their profit margins differently.

Three Margin Calculations

Gross Profit

Gross profit is calculated by determining the difference between sales revenue and the cost of goods sold, generally using the absorption costing method. All direct material, direct labor, and overhead costs (including fixed overhead) are included in the cost of goods sold. Gross profit is then used to cover sales, general, and administrative (SG&A) expenses.

Contribution Margin

The contribution margin is calculated by subtracting all variable costs from sales, even those that are considered SG&A expenses. This is an effective metric to help managers determine how fixed costs are covered. Some manufacturers may choose to focus on manufacturing contribution margin, which excludes variable SG&A expenses, and considers only variable direct material, direct labor, and overhead costs.

Throughput Margin

Like contribution margin, throughput margin focuses on variable costs. The difference is that in determining throughput margin, only direct material costs are subtracted from sales. Along with fixed overhead costs, direct labor and variable overhead costs are considered fixed in the short term (since likely, a business cannot act quickly enough to adjust these costs for immediate impact), so they are not included in the calculation.

The Pros and Cons

Gross profit is a common financial metric, used by manufacturers and non-manufacturers on financial statements. If your business provides its statements to external users, such as a lender, gross profit should likely be included on your financial statement. Further, to remain in compliance with Generally Accepted Accounting Principles (GAAP), absorption costing will be required leading to a gross profit calculation on the statements.

Contribution margin and throughput margin may be more useful for managers looking to evaluate the profitability of departments, product lines, or individual products. For instance, using absorption costing, fixed overhead may be allocated to product costs based on subjective measures that may not truly represent the cost to manufacture the specific product. However, when using contribution or throughput margin, these allocations are not considered and therefore, only the costs associated with directly manufacturing the product are included. These costs may more accurately help determine the benefit of producing or selling the given product.

Fluctuations in inventory can also impact gross margins generated by using absorption costing. In certain circumstances where production in a given period exceeds sales, gross income can appear higher due to the allocation of overhead charged to the cost of goods sold versus placed into inventory. This can be problematic, as it can incentivize managers to build inventory, especially if their compensation is tied to gross margin, despite negative impacts to cash flow or an increased risk for damaged or obsolete inventory. Contribution or throughput margins may be better metrics for determining such incentives.

To discuss methods that may help you assess your profitability, contact a member of HBK Manufacturing Solutions at 330-758-8613 or manufacturing@hbkcpa.com.