Corporate profits, according to the Bureau of Economic Analysis, grew by $20.4 billion in the final quarter of 2021, a 0.7 percent increase. For the first quarter of 2022, corporate profits fell by 2.3 percent or $66.4 billion. On an annualized basis, corporate profits fell 5.2 percent in 2022, but grew 25 percent in 2021. With the economy facing inflation, the uncertainty of the Russia/Ukraine conflict, and the world working its way out of the COVID-19 pandemic, economic uncertainty abounds. For companies, measuring margins is one way to evaluate performance and strategize ways to survive and thrive in a dynamic economy. Here are a few common margins that businesses can determine to measure their financial performance.

Operating Margin Defined

Also referred to as return on sales, this measures the profit a business makes on a percentage basis, per dollar, from its core operations. It accounts for manufacturing costs that fluctuate, such as paying employees and input stock. The operating margin is determined by obtaining the business’ earnings before interest and taxes (EBIT) and dividing it by its net sales or sales revenue.

Operating Margin = Operating Earnings (EBIT) / Revenue

Operating Earnings = Revenue – (cost of goods sold (COGS) + overhead expenses, except tax and loan servicing costs)

Assuming a business had $10 million in revenue, $1.5 million of COGS and $750,000 in related overhead expenses, it would be as follows:

Operating Earnings = $10 million – ($1.5 million + $750,000) / $10 million

Operating Earnings = $10 million – ($2.25 million) / $10 million

Operating Earnings = $7.75 million / $10 million = 0.775 or 77.5%

Understanding the Operating Margin

This doesn’t factor in things such as taxes, interest on loans or other non-core business expenses. However, it gives a picture of what’s remaining for its non-core operating expenses, such as servicing outstanding loans. By looking at a company’s past operating margins, the trends can determine a company’s performance. Ways to improve the margin include reducing staff redundancy, negotiating better deals on raw materials or reaching more receptive customers.

Marginal Revenue Product (MRP)

If a piece of equipment or employee can create an output of X (the marginal physical product or MPP) and each additional unit of production sells at Z price (marginal revenue or MR), the MRP of the piece of the new investment is MPP x MR. Accepting that all other costs remain constant, if the business owner pays less than or equal to the MRP, it may be profitable. Otherwise, it’s not a good decision.

Using the example of a furniture manufacturer looking to respond to increased demand, this illustrates how it can guide business decisions. If a new employee can produce 100 tables every week that will retail for $100 per table, this is the MPP. Based on the calculation, the MPP of 100 multiplied by the marginal revenue (MR) of $100 = $10,000. If the business can hire and retain a new employee for less than $10,000 per week to increase their production by 100 tables per week, it can signal a positive investment.

Marginal Cost of Production

This metric is a way for businesses to determine efficient manufacturing costs. Looking at production volume, this calculation can determine if adding an additional unit to production would add profitability by examining fixed and variable costs. Fixed costs don’t change with modifications in production levels.

A static or fixed cost can be spread out over more units of increased production. However, if expanding production capacity requires additional fixed costs, it can add to the marginal cost of production, which will be explained shortly. When it comes to variable costs, as the name implies, as more production occurs, the costs similarly vary.

Assume company A makes widgets with $1 in variable costs and fixed costs of $10,000 per month, producing 5,000 widgets monthly. This would lead to $2 in fixed costs ($10,000 in fixed costs/5,000 widgets).

This final cost per widget comes to $3 ($2 fixed + $1 variable cost).

If company A chose to produce 10,000 widgets a month and they could use existing machinery, employees, etc., their fixed costs would drop to $1 ($10,000 in fixed costs/10,000 widgets).

Assuming the same variable cost of $1 per widget, plus the $1 in fixed costs, it would cost $2 per widget if the 10,000 widgets were produced. However, if additional investments (equipment, etc.) were needed to produce widget 5,001 to 10,000, this consideration would need to be factored in the marginal cost of production. If additional equipment costs $1,000 to increase production, the business would need to factor this in to see if it’s still profitable.

Essentially, if this additional production cost is less than the price of an additional individual unit, there’s the potential for a profit for the business.

Contribution Margin After Marketing (CMAM)

This measures how much cash is earned from a single unit sold after accounting for promotional and variable expenses. Example expenses include input stock, freight, inventory, etc. It’s important to distinguish between pre-planned marketing expenses over a set period of time (per month, quarter, etc.), and variable sales commissions that can fluctuate. CMAM is calculated as follows:

Contribution Margin After Marketing = Sales Revenue – Variable Costs – Marketing Expense

Looking at how much each unit can add to a business’ profitability:

CMAM for every Unit = Sales Revenue for every Unit – Variable Expenses for every Unit – Marketing Expense for every Unit

From there, a business’ net profit or loss can be found using this ratio:

Net Operating Profit = CMAM – Fixed Costs

Considerations

A smaller or negative CMAM is indicative of a product that’s likely uncompetitive. Conversely, a high CMAM, especially over a long time, can indicate the product is well regarded. It can help businesses to determine their most profitable products and/or what products to discontinue, etc.   

With economic uncertainty expected to continue, keeping an eye on past, present and future margins is a key way to maintain a business’ chance of thriving in 2022 and beyond.

Sources

https://www.bea.gov/data/income-saving/corporate-profits

The Cash Conversion Cycle, also known as the Net Operating Cycle, answers the question, “How many days does it take a company to pay for and generate cash from the sales of its inventory?” However, before an analysis like this can take place, it’s important to consider the company’s primary line of business.

If the company sells software, it’s more challenging to measure performance if it generates revenue primarily on intellectual property – by developing computer code and licensing its use to clients. For online marketplaces, especially those that make the majority of their profits from third-party sellers that manage product sourcing, listing their inventory and shipping products on their own won’t measure the online marketplace’s own inventory. Since these types of businesses don’t act like a manufacturer that produces and sells products to other businesses or the general public, this type of analysis will be less helpful.

To start with the formula for the Cash Conversion Cycle (CCC), it’s calculated as follows:

CCC = Days of Sales Outstanding (DSO) + Days of Inventory Outstanding (DIO) – Days of Payables Outstanding (DPO)

Days of Sales Outstanding, Defined

DSO is the average number of days it takes a company to collect payment once a sale has completed. The beginning and ending Accounts Receivable figures from a fiscal year are added together and divided by 2. Then revenue from the income statement for the entire fiscal year must be divided by 365 days to get a daily average.

DSO = Beginning Accounts Receivable + Ending Accounts Receivable / 2 = Revenue / 365 days

The fewer the days, the better; however, it can’t be so fast that such tight payment terms push customers away.

Days of Inventory Outstanding, Defined

DIO is the average number of days a business keeps its inventory before it’s purchased.

The beginning and ending inventories of a fiscal year are added together and divided by 2 to find an average. The resulting figure is then divided by the daily average of the cost of goods sold over a fiscal year, which is often 365 days.

DIO = Beginning Inventory + Ending Inventory / 2 = Cost of Goods Sold / 365 days

The lower the number, the faster inventory is sold. While there’s nothing wrong with moving it fast, there is the danger that orders might not be able to be fulfilled.

Defining the Operating Cycle

As the CFA Institute explains, putting DIO and DSO together constitutes the Operating Cycle. This is defined as the period of days that it takes a business to transform basic materials and/or goods into stock and obtain money from the completed transaction. When this number is small, it means product is moving and customers have no issue making prompt payments.

Days of Payable Outstanding, Defined

Days of Payable Outstanding determines the number of days a business takes to fulfill its debts to suppliers.

DPO = Beginning Accounts Payable + Ending Accounts Payable / 2 = Cost of Goods Sold / 365 days

Considerations for DPO include finding a balance between how long a business can take to pay their suppliers, but also not missing out on pre-payment discounts or being penalized with late fees, financing charges, etc.

Going Beyond the Results

When analyzing the Cash Conversion Cycle for the right type of company, it can provide great insight into a company’s efficiency in collecting billings; how long inventory is up for sale; and the time it takes to become current with its own suppliers. Depending on the results of the CCC analysis, performing financial analyses can provide insight into not only how the company is performing financially, but why the company is performing financially.

Sources

https://blogs.cfainstitute.org/insideinvesting/2013/05/21/a-look-at-the-cash-conversion-cycle/