If you aren’t in accounting or finance, you may think that you don’t need to understand financial terms. After all, they are the experts, so what can you possibly gain by understanding your company’s financial numbers?
But, the thing is, everyone in your management chain is thinking about margin. And, your job is to make your manager’s life easier, so if you understand financial concepts, you better understand what is driving your management team’s decisions. And, when you understand why your management team is making the decisions they make, you put yourself in a better position to make their life easier.
You don’t have to be an expert – I agree – leave that to the accounting department. But, if you have an understanding of the basic concepts, you will be more successful in your career. You will also be able to make better decisions for yourself because you will be able to anticipate what your management team will do next.
The concept we are going to cover this week is margin. Margin is the amount of money left after you pay for all the cost.
Revenue minus cost equals margin.
In personal terms, we call it savings. Your revenue – your hourly wage or salary – minus your costs – taxes, rent, food, ballet lessons, orthodontist bills, car payment, and that Amazon Prime fee. What remains is your margin, or savings. For companies, it is the same. They take in revenue through sales and they have expenses. What is left over is margin.
And, as you can probably guess, the goal of every management team is to have the highest possible margin. So, as your management team makes decisions part of their decision involves understanding the impact on margin. I don’t mean to give the impression that it is the only factor, or the most important factor. Every business and every leadership team is different, so how your management team makes decisions will be unique. But, they are considering margin, so if you can understand this aspect of your company, you will be better able to understand one of the levers in your management team’s arsenal.
Margin, on the surface is a fairly easy concept to understand, but I’ve found over the course of my career that people really struggle with it. I think it is because there are so many factors that influence it. It is absolutely relative to the specific situation, so you must always understand the larger context of the business in order to understand the impact on margin.
To help paint a picture for you, I’m going to use a familiar example that we can all relate to. We are going to assume the roll of a hamburger fast food restaurant. Now, our restaurant has a standard burger that is made up of a bun, meat patty, lettuce, pickle, tomato & ketchup.
When a customer walks into the restaurant, they can see the price of this burger up on the board. They pay $2.99 for the burger and that $2.99 becomes our revenue.
We have a cost associated with delivering this burger to them. 1st, there is the cost of the ingredients. The bun, the meat patty, the pickle, tomatoes, lettuce, and ketchup. The accounting department tells us that the cost of these ingredients is 75 cents. So, we take in $2.99 in revenue and we spent 75 cents on the ingredients. You might think that the margin is 2.99 minus 75 cents. But, keep in mind that we also paid someone to make the burger. We also paid for the electricity to operate the grill. We paid rent on the building. We paid the manager to oversee the person who made the burger.
So, you have to include all of these costs. For our burger joint, let’s say all of these costs add up to $2.50. So, we sell the burger to our customers for $2.99 – which is our revenue. And it costs us $2.50, which means our profit is 49 cents.
Again, margin is what is left over when you subtract cost from revenue.
Now, let’s take a look at some of the ways margin can be impacted. Let’s say a customer comes in with a coupon for 50 cents off their burger. This means that our revenue is going to go down from $2.99 to $2.49. But, our cost didn’t change. It still costs us $2.50 to produce and deliver the burger. Now, the margin is $2.49 minus $.50, or negative 1 penny. So, when revenue goes down but costs remain the same, margin also goes down.
Think about ways that might happen at your company. What are the scenarios where revenue might decrease without costs changing? What is the equivalent of a 50 cent off coupon for your business?
Let’s look at another example. A customer comes in and orders a burger and asks or extra pickles. They don’t have a coupon, so they are paying $2.99 for the burger. This means that our revenue is $2.99. But, they asked for extra pickles. The cost of adding extra pickles to the burger is 5 cents. Now, the total cost has gone up from $2.50 to $2.55. So, even though our revenue stayed the same, our cost increased. This makes our margin 44 cents. $2.99 revenue minus $2.55 cost is 44 cents. Our margin has decreased from 49 cents to 44 cents.
Think about ways that might happen at your company. What are the scenarios where costs might increase? What is the equivalent of extra pickles for your business?
What if a customer walks in and orders a burger and tells you to hold the pickles? Sine we know it costs 5 cents to add pickles, we know that it saves 5 cents to hold the pickles. So, the cost of the burger goes from $2.50 to $2.45. Margin is now 54 cents. $2.99 in revenue less the reduced cost of $2.45 gives us a bigger margin of $2.54.
Think about ways that might happen at your company. What are the scenarios where costs might decrease? What is the equivalent of holding the pickles for your business?
Understanding the different levers that impact margin for your company helps you understand how healthy the business is. It may also help you understand ways that you can help impact margin by either improving revenue or reducing cost so that margin is increased.
There are a lot of various factors that can influence margin, and if you’d like to explore the topic more, I encourage you to check out our financial acumen curriculum, which is a collection of all of our episodes that explore the topic of company financials.
So, your homework this week is to spend some time thinking about your company’s margin. What are the things, like coupons, that impact revenue? What are the things, like extra pickles that impact the cost? Can you see how your management team is making decisions to move these levers in order to help improve margin for your company?
Everyone in your management chain – and everyone in a leadership position at your company is making decisions based on your company’s financial position every day. So, it is important for you to have some basic understanding about some of the core building blocks of financials. If you understand these, you are better able to understand why your leadership team makes some of the decisions they do. It helps to give you better insight. It helps you better understand the strategy decisions they are making. And, it helps you better anticipate what decisions they might make in the future.
Today we are going to talk about the difference between fixed and variable cost. If you can really understand this concept, you’ll have a better ability to analyze business strategy. So, this is fixed and variable cost 101.
Fixed cost is any cost incurred by your company that doesn’t change based on the business. So, for example, the rent paid for your office is fixed. Whether you make $100 in sales this month, or $1,000000, the rent is the same.
If you are in a manufacturing business that has large equipment – that equipment is a fixed cost. It is likely that there is some sort of monthly payment on the equipment that has to be made regardless of sales.
If you are in the transportation business, you likely have a fleet of trucks that are being paid for each month.
If you are working for a start up, maybe your company has taken out a loan. That loan payment is a fixed expense.
Chances are good that your company has some sort of insurance – whether it is liability insurance, key man insurance, or something specific to your industry. The insurance payment is fixed. It doesn’t change based on the volume of your sales.
The other type of cost is variable. Variable costs fluctuate based on volume. Inventory is a classic variable cost. Whatever business you are in, if it involves inventory, then your company can control costs by controlling inventory. You pay based on the volume you buy. So, if you are in a seasonal business, you would minimize the cost of inventory during the months that are not part of your season and your costs would go way up in the months that were your season.
What if you are in an industry that doesn’t involve inventory? Maybe you work for a software company or an accounting firm. In that case, the largest variable cost is salary expense. The amount of expense is going to increase or decrease based on the number of employees.
Services businesses like software, accounting, real estate, consulting – the largest expense they have is the cost of employees. So, the best way to control costs is to control headcount. In an accounting or consulting business where revenue is linked directly to headcount because you are literally charging by the hour – then the costs that the business incurs automatically goes up or down with the revenue.
For a software business – there isn’t as much of a direct link. You can sell a lot more software licenses without having to add more developers.
But, the fact still remains that salary expense is a variable cost because it increases or decreases based on the number of employees. So, your salary, regardless of what industry you work in, is a variable expense for your company.
Benefits are also variable expenses. Each time they add headcount, they also add expenses related to whatever benefits are offered.
So, you can start to see how understanding fixed versus variable costs is important. The leaders of your company have to make decisions based on the specific situation they are in. As they are making decisions, they have to look at the options based on what is variable and what is fixed. And, these aren’t always easy decisions. If you see your company making some belt tightening decisions, it could be an indicator that cash is tight and they are looking for ways to decrease variable costs in order to be able to ensure they can cover their fixed costs during a lean time.
And, on a side note – all of this applies at home as well. What are your fixed and variable costs at home? You are constantly making decisions based on this and may not even realize you are doing it.
You can learn more about financial acumen with our Financial Acumen Curriculum.
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