We regularly speak with CFOs and Finance Managers when working on a business transformation. Inevitably, the discussion turns to how they know which products make their business the most profit. The typical response is that they measure a product’s profitability by its gross margin percentage. We challenge this understanding by asking them when was the last time they purchased something with a percentage.
Of course you can’t purchase anything with a percentage; you need cold, hard cash. We then take our clients on a journey of re-evaluating their products by comparing the dollar value add per hour, which can give a very different appreciation of which products make the most money
Understanding maximum dollar contribution per hour
We are in business to earn the maximum dollar contribution per hour, and this may be higher on lower gross margin percentage (GM%) products than higher gross margin percentage products. Take the challenge in your business and do the exercise. Then apply the target dollar per hour number, e.g. $1,000 per hour, as your new measure for evaluating what work you want to bid for. Let your opposition quote on the gross margin percentages.
You can’t bank percentages; you can only bank dollars. Insist that everyone speaks in dollar values.
Let me give you an example. If I asked you to choose a product that was more profitable- which one would you select? Assuming each product takes 1 hour to manufacture or process.
Product A costs $60 to manufacture, let’s work on a 50% mark-up therefore it sells for $90,the gross margin on this product is 33%. This gives a $30 hour margin dollar contribution.
Product B costs $100 to manufacture and has a 40% mark-up, which means that it sells for $140.This product has a 28% gross margin and gives a $40 margin dollar contribution per hour.
Traditional thinking is to select Product A at the higher gross margin: 33% versus 28%. However, when we look at the margin dollar contribution, Product B contributes $40 per hour and Product A contributes $30 per hour. That’s a 33% higher dollar contribution per hour for Product B.
Ensure you know your gross profit dollar amount per hour, this is the magic number to track against for all products. It’s also advisable to monitor it against last year’s numbers, if your business is improving its efficiencies then this amount will also improve.
If it’s not, then investigate WHY?