Margin points are earned in three areas.
To be considered for contribution and net margins, a product must start the year with a plant and begin making sales on January 1. Products that are in R&D at the beginning of the year are ignored.
Why do margins matter? And why focus upon Contribution Margin, Net Margin, and Return On Sales? To simplify things, let's consider an example where you have only one product.
Example
REVENUE ($000) Awsum Product Awsum Sales $30,000 Price $30.00 VARIABLE COSTS Labor $7.00 Direct Labor $7,000 Material $11.50 Direct Material $11,500 Inventory Carry $0.50 Inventory Carry $500 Unit Margin $11.00 Total Variable Costs $19,000 Units Sold 1,000,000 Contribution margin $11,000 36.7% PERIOD COSTS Depreciation $2,000 SG&A: R&D $500 Promotion $1,300 Sales $1,100 Admin $300 Total Period Costs $5,200 Net Margin $5,800 19.3% Other (fees, write-offs) $100 EBIT $5,700 Interest $2,500 Taxes $1,120 Profit Sharing $50 Net Profit $2,030 6.8%
Contribution Margin is defined as Sales less Variable Costs. Variable Costs are the expenses that are tied to the sale of each unit. They are recognized when a unit is sold. Because the number of units you sell varies with demand, they are called Variable Costs. In the example above you sold 1 million units. If you had sold 2 million, your Variable Costs would have been $38 million, but if you sold 500 thousand, they would be only $9.5 million.
In short, you do not know your Variable Costs until the sales numbers arrive.
Period Costs, on the other hand, are not tied to sales. In the example above, you spent $5.2 million on Period Costs whether you sold anything or not. While you could not say what your Variable Costs were until December 31st, the Period Costs were known on January 1st.
Net Margin is defined as Contribution Margin less Period Costs. Put simply, it is what the product contributes towards profits.
From the combined Net Margin (normally across all products) you pay the expenses that cannot be allocated to a product. First comes "Other" (expenses like brokerage fees), then Interest, Taxes, and Profit Sharing until you are left with a Net Profit.
Have another look at the example. Notice that all the expenses from the PERIOD COSTS label down are either fixed or a percentage of profits. The moment you submit your decisions, everything but Profit Sharing and Taxes is known, and they only occur if you produce a profit. Those known expenses total ($5,200 + $100 + $2,500 = $7,800) or $7.8 million. If your Contribution Margin cannot cover $7.8 million, you are destroying wealth instead of creating it.
In the big picture, you cannot have a decent ROS unless your Net Margin Percentage is good, and you cannot have a good Net Margin Percentage unless your Contribution Margin Percentage is healthy. In Capstone®'s industry, this translates to a 10% ROS, 20% Net Margin, and 30% Contribution Margin.
Finally, consider your detailed Income Statement in your Annual Report. Typically, some of your products are producing healthy margins, while others are slim to negative. Your task is to improve the margins on the poor performers. Are Period Costs too high? Are Sales, and therefore the Contribution Margin, too low?