The Key To Long Term Profits

Creating competitive advantages is the only way to increase long term profits and cash flow.

By creating competitive advantages, manufacturers have flexibility and options.

For example, a cost advantage allows the business to manufacture the same products as competitors, but at lower cost per unit. This allows them to be price competitive, or even undercut competitor pricing to attract higher sales volume while maintaining or increasing total profits. Or the savings from the cost advantage can be invested into other areas of the business to create new competitive advantages.

Achieving a single competitive advantage will create a virtuous feedback loop.

As profits increase from creating a one competitive advantage, those additional profits can be invested to create additional competitive advantages in other areas of the business. Each advantage compounds profits, which can fuel future growth.

The Lack of Visibility

The problem is most manufacturers under $10 million in annual revenue do not have a finance function capable of presenting financial data in a format that allows them to properly assess their current state and determine what needs to change in order to create competitive advantages in the future.

Far too often, the only numbers that are readily available are from standardized financial statements. This makes evaluating performance difficult. It's not your bookkeeper or accountant's fault. They are taught to format financial information in a specific way that allows creditors and investors to evaluate a number of businesses across a variety of industries. But this standardized reporting is not useful to owners and managers who work inside the business. We need a different format to make the best decisions based on underlying performance drivers.

Looking at business performance on a consolidated basis is only so useful. The consolidated view distorts the true performance of different segments, such as product type or customer. It's impossible to tell which products or customers are contributing to the overall profits and which ones are actually creating losses.

Standard profit & loss (P&L) statements don't allow you to see what is really happening in the business. Are we more profitable than last year due to a price increase for a given product? Did we increase sales volume? Were new products introduced or old products eliminated? How have our costs per unit changed?

All of these are unanswerable with standard reporting.

Without being able to drill down to the specific drivers of the business, we are stuck unable to determine what to change to increase future performance. We aren't able to see the areas we are excelling at and where opportunities for improvement exist. We're flying blind.

So, how can manufacturers create the financial reporting required to build and sustain competitive advantages and increase long-term financial performance?

Creating An Actionable Decision Framework

Unit Economics: The Profitability of a Single Unit

The first financial reporting format we need is unit economics.

Unit economics transforms standard P&L information into the revenues and costs associated with a product, customer, or other segment as a single unit sold. This is extremely useful for evaluating performance, especially when compared to prior year results or budget/forecast numbers. We can make this even more useful by rearranging costs based on how they behave (fixed costs that do not change when volume changes versus variable costs that fluctuate with changes in volume) instead of how they are classified on standard P&Ls (Cost of Goods Sold versus Selling, General & Administrative Expenses). This presents your financial data in an actionable framework to guide profitable decision making.

The calculation of unit economics is straight forward. You simply take the revenue, variable costs, and fixed costs for a given segment (company wide performance, a specific product, a specific customer, etc.) and divide those relevant amounts by the associated sales volume. This gives the business the revenue, variable cost, and fixed costs per unit for that segment.

By identifying which products, customers, and other segment are the most profitable and which ones need improvement, the business can make decisions to optimize pricing, reduce cost per unit, or even eliminate underperforming products or customers to free up production capacity to pursue more profitable areas.

To gain a complete financial picture, we need to use our per unit metrics within Cost-Volume-Profit (CVP) Analysis to ensure we are making the optimal decisions.

Cost-Volume-Profit (CVP) Analysis: The Key to Making Better Decisions

CVP Analysis uses unit economics to determine how changes in selling prices, costs, and sales volumes affect total profits.

This is why we want to group costs based on how they behave. It allows us to easily see how profit levels change with changes in sales volume. Both Cost of Goods Sold and Selling, General & Administrative Costs have elements of fixed and variable costs. If we don't separate how costs behave, our profits become distorted when we try to see the implications of sales volume changes.

CVP analysis is helpful to determine what would need to be true in order for a given product, customer, or other segment to be profitable. We may need to change our selling price in order to return an acceptable level of profit. A certain level of sales volume may be needed to cover fixed costs. Or our selling price levels may be capped due to competition, forcing us to figure out ways to reduce costs in order to return a desired level of profit.

Once unit economics and CVP analysis are established, we can determine which levers to pull in order to improve future performance.

This requires focusing on 3 key competitive advantages:

1. The Cost Advantage
2. The Sales & Marketing Advantage
3. The Value Advantage

Without a plan to improve these critical areas, we are simply shuffling numbers on a spreadsheet. We need to identify the specific actions that will create these competitive advantages, which allows the business to dramatically improve performance. Achieving just one competitive advantage will inevitably lead to creating other competitive advantages.

The Cost Advantage - Getting More Output For Less Input

A Cost Advantage is established when a manufacturer is able to produce products for a lower cost per unit than its competitors.

This starts by identifying the underlying cost drivers of production.

Cost drivers are the activity that increases or decreases costs. Examples of this include labor hours or machine hours. As either of them increase, we would expect our costs to increase as well. By pinpointing the specific components or processes that contribute the most to costs, manufacturers can implement improvements to reduce per unit costs.

The 3 ways to create a Cost Advantage include:

1. Systems & Processes
2. Technology
3. People & Talent

Each of these can boost productivity, which in turn allows the manufacturer to produce more output for less input, and reduces per unit costs.

Establishing a Cost Advantage allows the business of offer competitive pricing, increase profit margins, and/or reinvest savings into other areas of the business to create new competitive advantages.

The Sales & Marketing Advantage - Increasing Your Customer Base

No matter how great your production is, you will not be able to grow if prospective customers don't know you exist.

Without establishing a Sales & Marketing Advantage, your competitors will be able to get in front of your prospective buyers and convert them into customers before you even get the chance.

A Sales & Marketing Advantage allows the business to effectively allocate spend to enable consistent new sales and grow their customer base. A strong pipeline of production orders helps with creating a Cost Advantage as well. A higher level of production spreads fixed costs over more units, reducing per unit costs.

The 3 key areas to creating a Sales & Marketing Advantage are:

1. Generating Quality Leads
2. Converting Leads into Customers
3. Retaining Existing Customers

Each of these key drivers increase the overall customer base. When per unit metrics and CVP analysis are properly utilized, it helps inform the optimal selling prices and purchase order sizes required for profitable sales. This helps cut down accepting purchase orders that generate top line revenue, but actually reduce profits, instead of increase them.

When the key sales & marketing drivers are identified, the business can set realistic sales volume forecasts based on sales & marketing spend allocations that achieves profit targets.

The Value Advantage - Increasing Pricing Power and Escaping Competition

The final competitive advantage is the Value Advantage.

Value is simply the ratio of benefits a customer receives relative to the price they pay for a given product. The higher the ratio compared to competitors, the more likely the prospective buyer will opt to do business with you. A value advantage makes creating a Sales & Marketing Advantage that much easier.

The 3 areas of focus to create a Value Advantage are:

1. Market
2. Experience & Quality
3. Product

Each of these areas increases the benefits a customer receives,, making doing business with you far more attractive to prospective buyers. The higher the value to price paid ratio, the higher pricing power the business has. This leads to higher levels of profit.

Each competitive advantage helps create new ones. A higher Value Advantage makes achieving a Sales & Marketing Advantage easier. A higher Sales & Marketing Advantage leads to creating a Cost Advantage as fixed costs are spread over more units. A higher Cost Advantage makes creating a Value Advantage easier to achieve by freeing up resources to improve the benefits a customer receives.

What to expect next:

Our upcoming content will focus on calculating unit economics. We'll use these in our CVP analysis to unlock additional insights that help create competitive advantages.

Our content over the next coming weeks will focus on:

• Unit Economics: The Profitability of a Single Unit - This covers how to determine which products and customers are profitable and which ones aren't.
• CVP: Breakeven and Profit Point Analysis - How to calculate the sales volume levels required to not lose money and to hit a desired level of profits.
• CVP: Sensitivity Analysis and Margin of Safety - How far actual results can deviate from your assumptions and still hit your targets.
• CVP: Use Case Examples - Specific examples of how to use CVP to make profitable decisions