Profitability is a mandatory requirement for long-term operating success and the building of shareholder (owner) wealth. A key to profitability is having a pricing model that accurately accounts for both fixed overhead and variable expenses.
The use of traditional accounting classifications, cost of goods sold and operating expenses, often clouds the distinction as to which expenses are actually fixed and variable. Adopting a model that accurately categorizes fixed and variable expenses can result in pricing strategies that achieve optimum profitability.
The Construction Material Manufacturer
The client we were assisting was a manufacturer of construction material sold to commercial and residential contractors. The Podolny Group was working with this client to develop a long-term wealth growth plan. The key to this plan was the optimization of free cash flow available to be distributed, which in turn required increasing the profitability of the company’s operations.
One vital factor affecting company profits was the erratic nature of volume. It was the normal course of a year to have some months where the company was flooded with work and others where it was scrambling to fill the plant. The company used a traditional pricing model. It estimated the costs of a job in terms of material and labor, then applied a mark-up that, in theory, resulted in the desired Gross Margin. However, in practice the company’s overall Gross Margin was always less than the target.
Shedding Light on the Factors Actually Driving Profitability
As we analyzed operating procedure, we noted a factor that was not being accounted for in the pricing model. The client’s direct labor was not in reality variable. The company had a core of trained personnel. It was felt that these people needed to be maintained even during the periods when business volume was reduced. While the pricing model assumed direct labor to be variable, it was in fact fixed.
We proposed an alternative model. This model took direct labor and placed it in the fixed overhead. It took certain manufacturing supplies that were included in operating expenses and combined them with material costs. This resulted in a new factor, the Marginal Contribution of each sale toward fixed overhead. Using this factor, we changed pricing policy. Instead of trying to earn a target Gross Margin number per job, the new goal was to earn sufficient Marginal Contribution to cover the monthly overhead number each month as early in the month as possible. Once overhead was covered in any given month, 100% of the Marginal Contribution went to the bottom line for the rest of the month.
The new model drove a change in the client’s bidding and pricing procedure. The company became much more flexible in its pricing depending on the scheduled volume during any given month. As each month’s volume resulted in reaching the overhead breakeven point, pricing was adjusted to fill the month with a goal to optimize the dollars of profit. When months were slower, there was less concern with making profit and bids were more aggressive to ensure that the monthly overhead was covered. Avoiding a month where fixed overhead was not covered became a priority. The result over the next two years was a substantial increase in corporate profits and free cash flow available for the owner’s wealth building program.
Companies serious about driving profitability should consider revisiting their pricing models in the light of assumptions about variable and fixed expenses.