Margin points are earned in three areas.

• Contribution Margin Percentage (Up to 33 1/3 points). Each product with a contribution margin greater than 30% earns points. If all products have contribution margins greater than 30%, you earn 33 1/3 points.
• Net Margin Percentage (Up to 33 1/3 points). Each product with a net margin greater than 20% earns points. If all products have margins greater than 20%, you earn 33 1/3 points.
• ROS or Return On Sales (Up to 33 1/3 points). ROS is defined as (Net Profit / Total Sales). ROS looks at the entire company's after tax margins. You earn 33 1/3 points for an ROS of 10% or greater. You earn nothing for a negative ROS. An ROS between 1% and 10% is scaled. For example, an ROS of 5% would earn 16.65 points.

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.

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.

In the simplest sense, when you make 1 million units, the transaction occurs on the Balance Sheet. You buy materials and labor with Cash from vendors (Accounts Payable), converting them to Inventory. Even the labor (your employees making the units) can be thought of as outside vendors. For that matter, they could be. The only people in your company that show up on the Income Statement are part SG&A expense, which we will come to in a moment.

When you build a unit, you are converting Cash into Inventory.

When you sell a unit to a customer, the Income Statement "buys" the unit from the Balance Sheet and posts it to Sales. For your convenience, it then breaks down the costs of that unit into Direct Labor, Direct Material, and Inventory Carry (the cost of warehousing the unit until it was sold), but it could just as easily have lumped it all together as "Cost of Goods 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. Period costs include people that are not tied directly to the cost of producing a unit — administration, salespeople, and managers, for example.

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.

What is critical here?

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 Foundation™'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. Consider these questions: Are Period Costs too high? Are Sales, and therefore the Contribution Margin, too low?