Profit Margin

Understanding how a firm defines "profit margin" often tells a lot about how the firm is managed and the potential long term viability of the firm. I have seen many types of margin used -- some I could not explain if my life depended on it.

Gross margin, net margin, contribution margin, variable margin, EBIT margin, EBITDA margin, etc. I am sure I am missing many other options. The ones I typically focus on are EBITDA, and to a lessor extent EBIT. I find these most conducive to the philosophy of focusing on cash and creating a return on investment.

What I would like to spend some time on are the problem "margins" -- the ones I find being used in companies that have gone south and have helped contribute to going south, companies that "somehow" can't seem to find any profit: contribution margin and variable margin.

What these have in common is a conscious choice to ignore some cost -- everyone's favorite to ignore, G&A; next on the list, fixed overhead, etc. The justifications include the desire to win a program that is marginal financially (in fact, to price below fully burdened cost), or the desire to focus on operations but not support, or a desire to look at costs that management can "control."

All of these reasons are just excuses to not manage costs. Every time a program or project is priced below cost, the company is introducing a new competitor to the market -- and one that the company can never beat...that new competitor is itself, but always a lighter version.

A desire to ignore G&A is exactly what is convenient for the guys in the office. This way the lack of discipline in corporate is not made visible, and in fact the message is sent that this cost is not very important or not anyone's business.

Setting aside fixed costs and looking at variable margin implies that recovering machinery, equipment, and building expenses is not necessary. Or that somehow parts will spontaneously appear from nowhere.

The most stunning is the idea of focusing on costs that management can "control." It is impossible to have any item of cost that someone in management is not responsible for. And whoever is responsible for it must be held accountable to manage it. This one always amazes me, and I have heard it too many times. Management actually stands up and "admits" that they cannot control some portion of cost. If this is true, what use is management?

The bad message is reinforced -- not all cost is important. As if some dollars being spent are less important than others, or have less impact to the bottom line. Management is taught that there are some costs worth worrying about, and some that are unimportant -- or beyond their pay grade.

Such a practice creates a crutch, and a self-reinforcing one. The company develops a culture of dependence on subsidy, as if some benevolent father is covering part of the tuition bill.

Whenever I come across such a situation -- contribution margin, variable margin, etc., I ask which costs are being excluded. At a minimum, it is G&A. I then ask the management if they are agreeing that on such programs they are willing to give up that portion of their own compensation -- after all, what they are suggesting is some portion of their own personal costs will not be born by the company but subsidized by the shareholder.

Even this could be acceptable if the practice was managed strategically relative to opportunities -- with offsetting higher expectations on other opportunities. However, what I have found is that the line has continuously moved, until every program, every opportunity is looked at on less than full cost. In some ways, this is inevitable -- once dependence sets in, it is difficult to create the discipline needed to keep this in control.

Do not allow someone in accounting to convince you that the company can grow itself into profit by selling product at a loss. Don't allow the taste of this drug to seep in. Once it does, it will be difficult to keep it contained -- in fact, it will consume you.