A Better Way to Understand Product Profitability

A Better Way to Understand Product Profitability

Many companies calculate product profitability by subtracting a Standard Cost from the Price and calling it a Margin. But this calculated margin does NOT tell you how much money you are making. It tells you almost nothing about the profit you are making because the standard cost is made up from a lot of tenuous allocations.

So what’s a better way to look at this? We have had some good success with calculating Contribution per Minute. This method gives you real information about how much money your products bring into the business in comparison with other products. It also works well for figuring out customer profitability.

What Is Contribution Per Minute?

Here’s the equation:

Contribution/Minute = (Financial Contribution / #Minutes through the Bottleneck Operation)

A simple example: if you have a product that sells for $1,000 and the Material Cost is $400 and the cycle time through the bottleneck (or constraint) operation is 10 minutes, then the Contribution/Minute is = ($1000-$400)/10 = $60

You can calculate this for each of your major products and then compare the relative financial impact of selling those products. You can accumulate these numbers across product families, and you can calculate the true financial impact of servicing particular markets and customers.

There’s a Little More To It Than This

Strictly speaking, we calculate financial contribution as the revenue received minus the variable cost of making the product. The variable cost includes the material costs and any other costs paid for outside of the company. An outside process (like heat treatment, for example) would be a variable cost. Labor time and machine time would NOT be variable costs because these costs are largely fixed from one day, week, or month to another give or take some overtime costs. Your company is paying your people irrespective of what they make; and similarly for the machines.

If you manufacture in batches and have significant change-over or set-up times, then you may need to add (change-over time/batch size) as an extra amount of time in the bottleneck minutes.

There is sometimes a need to make adjustments based on other processes outside of the bottleneck if there is a wide variation of process choices beyond the bottleneck. But this is usually not the case when you have well defined Value Streams.

How Does This Help Me?

photoI have been working with a company that makes large forged components used in industrial machines and vehicles. They have two value streams; one for large forgings and another for smaller forgings. The production process has 7 or 8 steps and the bottleneck operation in each of the value streams is the actual forging process itself. The forging process determines the rate of flow of the product through the whole value stream.

This company calculates the Contribution/Minute for each item (or batch) that flows through the value streams, and sums these up throughout the day. This enables them to monitor the amount of money being generated for the business in a very dynamic way.

Their sales and marketing people use the same information to understand the financial impact of their sales plans and marketing campaigns. They strive to optimize the production mix based on the markets, the customers, and the financial contribution. They also keep track of the cumulative Contribution/Minute for their major customers and specific markets.

The people designing new products use the same information when target costing the products and this leads them to design for maximum flow and maximum contribution.

Why is This Better Than Standard Margins?

This is a much better way to calculate the relative profitability of your products, markets, and customers because the Contribution/Minute is a REAL number. It actually shows you how much money is going into the bank as a result of your work.

A Standard Cost Margin does not tell you anything about how much money is going into the bank. In fact, Standard Cost Margins almost always lead to poor decisions. Companies take orders that make very little money but show a good margin, and also turn down good profitable orders because the margin is too low. These decisions (made in good faith but with poor information) are damaging to the company. Similarly, these companies often outsource production and others services when in fact the most financial benefit would come from making them in house; and vice versa. I have seen these dangerous misunderstandings occurring in many different companies large and small, lean and non-lean.

Another thing Contribution/Minute does for a lean company is to focus attention on the flow. Everybody from sales to operations, purchasing and accounting is consistently making decisions based on flow rate. Contribution/Minute motivates lean improvement to eliminate waste and free up capacity so that more product can better flow through the value streams. Standard costing methods have the opposite effect; they undermine lean.

Important Conclusion

Measuring Contribution/Minute is a smart way to run a production business because it is one simple calculation that everybody can understand; it give you real bottom line numbers that lead to greatly improved financial results; and it drives solid lean behaviors and improvement.