Without a basic grasp of financial concepts at the C-suite (executive) level, small and medium-sized manufacturers (SMMs) may be limited in their ability to compete in an increasingly crowded marketplace. This is why financial literacy is near and dear to my heart.
As a former manufacturer myself, I understand how SMMs impact the way we live, work and play. As CEO of Manex Consulting, I work with many SMMs through California Manufacturing Technology Consulting (CMTC), which is part of the MEP National Network™. Your local MEP Center offers a powerful combination of knowledge and resources, with connections to expert consultants like me.
Building your financial literacy, beginning with your C-suite financial vocabulary, is a great way to increase your competitive edge. In this blog, I will illustrate the importance of financial literacy in manufacturing, including some of the most important concepts that impact your business operations.
The importance of growing your financial vocabulary
Let’s face it, finances may not be your favorite part of your job. I work with many machine shops and advanced manufacturing operations that got into this business because they are passionate about technology and innovation. They spend countless hours on continuous improvement and lean best practices on the technical side of the business, but they don’t pay as much attention to the financial side. What they don’t realize is that growing their C-suite financial vocabulary is an equally important part of continuous improvement.
I know that a thousand dollars to a small manufacturing company is like a billion dollars to a large company. I ran a $12 million home decor manufacturing company. We mainly made fireplace equipment, though we branched out into other items. I can tell you from experience that every dime counts!
Gross profit margin is the starting point of profitability – or loss
I was coaching someone a few years ago and going over her company’s finances. I discovered that she was giving huge discounts to several key customers, which was lowering her gross profit margin. She was under the impression that she had a high gross profit margin, and it turned out this was not the case. At the end of our conversation she said, “I should be paying more attention to this. I was a finance major in college.”
I almost hit the floor! Gross profit margin is one the most important financial concepts in manufacturing because it drives operating profits, net profit margin, and overall revenue. Think of it as the starting point of profitability or loss.
How gross profit margin relates to your manufacturing operations
For any manufacturing business, gross profit margin is foundational to the rest of the income statement. It drives everything. It pays for the overhead. It allows you to invest in research and development. So, the greater the gross profit you can achieve, the greater the growth potential for your company.
Here are some things to consider that relate to your gross profit margin:
Cost of goods sold. Your gross profit depends on the costs involved in the production of an item: the cost of goods sold (COGS). Your COGS benefits from lean and 5S, as well as supply chain management negotiation. COGS drives your gross profit margin.
Net profit margin. So, how does gross profit margin relate to net profit margin? Net profit includes your sales, general and administrative costs. Gross profit margin covers your cost of goods produced. These include payroll, rent and taxes.
Pricing strategy. I like to think about gross profit margin in terms of pricing strategy. Are you leaving anything on the table? Many small manufacturers are afraid to raise their prices. But after the pandemic, many discovered their customers were willing to pay higher prices. Your top line is a key driver of gross profit margin.
Dangers of discounting. Discounting for volume is one of the least understood and most dangerous drivers of net loss. As an example, if your current gross margin is 35% and you offer a discount of 5%, your company will need to sell just under 17% more to earn that same gross profit. A 10% discount would require 40% more units to drive the same gross profit before the discount. Be careful with discounts.
C-Suite concepts to add to your manufacturing vocabulary
Benchmarking
You want to have pricing power whenever possible. This is where benchmarking your company with other companies like yours can help.
You can benchmark financial and operating metrics against other companies in your industry. Start with industry studies to look at similar companies. Look at their financial ratios, labor costs, revenue per employee and other metrics related to your business model. Many of these reports are available at your local MEP Center.
When looking at other companies in your industry, ask yourself: “What do we do better than these companies? What is our realistic gross profit margin?”
For example, if you see companies similar to yours with an average revenue of $245,000 per employee, and you’re at $150,000 per employee, you might start looking at your company’s productivity metrics and processes. Where are opportunities for improvement?
Days’ conversion to cash
“Days’ conversion to cash” refers to how long it takes you to convert something to cash. You are building discrete goods and you have to pay for everything up front, including all supplies. You have to pay for all the labor to build it. You have to pay for the packaging. And you have to pay the trucking company to ship it out. You also may have 30-day or 60-day terms before receiving payment. Whether you’re the owner of a manufacturing company or in another leadership role, you need to pay a lot of attention to how many days it takes to convert to cash.
C-Suite vocabulary boosters
If you don’t have one already, I recommend buying a financial dictionary. There are pocket versions that make a great desktop reference tool. Here are some more C-suite terms you may want to bookmark in your dictionary.
- EBITDA: Your EBITDA is your earnings before interest, taxes, depreciation and amortization. This term describes your company’s overall financial performance. Your gross profit is going to pay your company’s rent, administrative costs, marketing, staff, lease and so forth. Then it’s going to feed into your net income, which will become your EBITDA.
- Balance sheet: Your balance sheet is essentially the history of your company’s financials. You should be able to look at your cash flow projections via your accounts receivable and backlog, so you can let your owner know what the company’s 30-day and 60-day cash positions look like.
- Debt ratios: Debt ratios that account for your company’s debt load are something to look for on your balance sheet. If you can, consider carrying some debt to get new projects and new customers. Your bank or financial company will establish loan covenants that include debt considerations. Keep an eye on your performance metrics, as they impact your covenants, and the loan could be called.
Real-world examples show how working with MEP experts can help
MEP experts across the country can help boost your financial literacy. For instance, here are some examples of how I helped manufacturing companies through tough situations.
One company I worked with started with 36 employees and an annual revenue of around $6 million. Today, it’s close to $40 million and has well over 100 employees. During this growth period, it outgrew more than one bank. The company needed a way to present its potential growth value to each new bank.
I worked with it to create a financial deck that it could present to each new bank. Because the company communicated with its banks at a C-suite level, it had access to new capital to grow its business!
Many startups in the consumer goods industry have a solid business foundation and marketing knowledge but lack a C-suite-level financial foundation. One family-owned startup considered expanding its operations into a different niche in its industry. After working to understand the financials involved, it realized that the operational improvements would be too costly for the expansion to be profitable.
The company avoided financial disaster by participating in a state-funded program that helped it increase its financial literacy and make better business decisions. Through the program, the company made safety and equipment improvements that enabled it to increase production. This included food safety training and other foundational elements for business growth.
BIO:
Manex Consulting provides operational and financial consulting to small- and medium-sized manufacturers as a part of the California Manufacturing Technology Consulting network, which is part of the MEP National Network. Gene Russell has held three successful CEO positions over a 20-year period at organizations including early-stage, private equity and nonprofit. He has served as senior leadership for global Fortune 100 companies and iconic consumer brands.
Prior to joining Manex, Russell led a turnaround at a California medium-sized manufacturer. He offers SMMs real-world experience and a personal passion to restore and invigorate domestic manufacturing.