April 08, 2021 | Blog
Product Profitability is like looking through a glass bottle.
In today’s world, investors deserve to know precisely how much profit their manufacturing assets are generating. It is the rationale for the quarterly earnings call; “how much profit did we make in the prior 90 days?” Since there are 24 hours in a day, the question is really, “how much did we make in the last 2,160 hours?” Investors rightfully expect financial precision, and looking forward, every manufacturer needs to see with 20/20 vision.
If this is the case, then why do manufacturers apply traditional accounting when it blurs their view?
Let’s show you what looking through a glass bottle is like: say, you run a large manufacturing business that makes thousands of different products. Let’s focus on just two of those products. By looking at the per-unit margin, you see that Product A sells for $50 and Product B sells for $25. Studying this metric alone, you’re given the impression that Product A is two times more profitable than Product B. You might be asking, doesn’t that mean Product A generates the best return?
I see your question, and I’ll raise you a question: What happens when we factor in how many units can be made per hour? Let’s say it takes 1 hour to produce Product A, while it takes 20 minutes to produce Product B. Suddenly, we realize Product B generates $75/hour compared to Product’s A $50/hour, a whopping 50% more. While that’s a very simplistic scenario, it helps make the point, as we like to say, “Fast nickels are better than slow dimes.”
For complex manufacturers, who typically produce hundreds of different products, traditional cost accounting methods distort the baseline profit measures decision-makers require to manage the business.
As demonstrated by the simple example, the distortion created by traditional accounting methods is profound. This technique not only harms the managers who are charged with running a manufacturing business, but it also harms the stakeholders who own the enterprise.
Return on equity (ROE) is a major component of what an investor looks at when evaluating the performance of various investments. Luckily, there’s just a formula to calculate ROE:
This is the Dupont Profit Formula. While it is part of the bedrock of corporate finance, many finance leaders seem to have misplaced it.
Accountants relentlessly pound away at costing studies, standards-setting, activity-based costing, and unit margin analysis. It is the never-ending effort to perfect the performance data for each of their many products. While this unit margin data is important, it’s woefully insufficient by itself. To our way of thinking, cost accounting has obfuscated finance, and it is a travesty for complex manufacturers.
Profit Velocity brings financial brilliance to the forefront. Our methodology is fast and easy to implement for business managers to accurately visualize value capture opportunities hidden in the mix. Next time you are asked, “How much are we making on that?” Your answers will provide 20/20 vision rather than a distortion of the view.