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🔐 Unit Economics Part III: Securing Your Margins

The best tool for understanding unit economic variances

A word
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Working

An attack on the cost base

It was in mid-2020 (a few months into the pandemic) when it started to dawn on me the extent of the stimulus pumped into the global economy.

At that time, who knew what the short-term effects would be.

But one thing, in my mind, was certain. In the long run, this had to end in inflation. Serious inflation.

That would mean the end of near-zero interest rates.

I met with my leadership team around that time and we agreed that we needed to run scenarios on inflation and interest rates in our upcoming Long Range Plan. This wasn’t something any of us had done (beyond lip service) in a long time. Nearly 15 years.

We all agreed high inflation and interest rates were something we should expect.

The only question was when.

And we didn’t have to wait too long.

We started to see serious signs of inflation in the first half of 2021, and by the summer it was clear it was an onslaught. Across the board. Shipping costs. Energy. Labor. Steel. Timber. Industrial chemicals.

You name it, it went up.

The only surprise was that it took the Federal Reserve and other central banks so long to act (most didn’t move rates up until early 2022).

While my team had seen inflation coming, the magnitude and speed caught us off guard.

The cost base was under attack on all fronts. It was enough to wipe out our entire operating profit many times over. We had to mitigate the impact and do so in a way that didn’t destroy our unit economics.

First we had to wake the business up to the new reality. Frankly, before that even, we had to wake the finance team up.

We were used to dealing with breakout inflation on one input cost line. A micro factor driving a particular commodity, or piece of regulation.

But this was not that. All cost lines were going parabolic. Unclear when it would stop.

And it wasn’t just about the P&L. It was big enough to affect our cash conversion cycle. Our capex budget got blown out by steel and timber inflation too. This was not a problem we were used to.

Every time we thought we had our finger on the impact, something big would move. A constant shifting sand.

The big question had been: “How much does all this cost?”

We quickly realized that was the wrong question.

The right question was “How do we change our business model given we have no idea how much this will all cost?”

An existential crisis.

Time for a deep breath


Deep Dive

This is the final part of a three-part series on unit economics.

Securing Your Margins

In Week 1 of this series, we talked about unit economic theory.

Last week, we talked about how the P&L behaves in practice.

So, you have your target unit economics set. And relevant ranges.

What could go wrong?

Well
 potentially anything could go wrong. Actually, potentially EVERYTHING could go wrong. And at some point, it probably will.

You can mitigate this by ensuring the budget reflects your target unit economics. And then measure your actual performance against that budget. 

That way you’ll know whether you are on plan or not


It’s a start. But this will only tell you at a high level whether you hit gross margin or not. And whether you missed sales volumes or not.

It doesn’t tell you what you really need to know, which is WHY & WHERE. It’s only by understanding why and where variances have occurred that you can decide what needs to be done.

For example, if your business missed gross margin because input cost prices went up. Or unit production per hour was down. That’s useful information. But it’s far more useful if you know where, which products, & why.

The best answer to business problems rarely sit on the surface wearing a name badge.

But to get that granularity you need a tool that can connect the financial statements down to product detail. Something that ensures the micro-decisions made day by day, product by product, reflect the intention of the sum total. These are short-interval controls.

The best tool I have seen for understanding unit economic variances is standard costing accounting.

⏰ INTERIM AUDIT ⏰

What are your experiences with standard costing? Do you use it? Do you like it?

Reply directly to this email with your answers!

Let’s dive in.

What is Standard Costing?

Not to be confused with stranded cost, which is a different concept altogether.

Standard costing accounting is a tool for extrapolating the planned unit economics of individual products and comparing that to the actual performance. Used properly it integrates across all accounting and finance processes. And ultimately gives an extraordinary level of detail in planned vs. actual variance analysis.

Let’s work an example


You are a manufacturer of luxury belts that cost $80 per unit to make. Broken down as follows:

  • The belts are made of the finest materials only:

    • Each belt requires 40 square inches of well cut leather. The leather is cut from a sheet resulting in 10% waste. Leather costs $0.90 per square inch.

    • The buckle costs $10 each and the end tips cost $1 each

  • The labor required to manufacture the belts are the most skilled leather craftspeople in the world:

    • Each belt requires 20 minutes of an expert leatherworker at a cost of $48 per hour (3 belts per hour)

    • The leatherworkers are overseen by a supervisor who spends 5 minutes per belt at a cost of $96

  • The variable overheads for each belt are $5 (consumables, tooling, energy for machines)

The belts are sold to merchants and priced at $200 wholesale.

From the above, we could build a bill of materials and standard costing card for the belts as follows.

Standard Cost Card

Standard Cost Card

Bernard, the general manager for our belt business, is expecting to sell 100,000 of these belts at a 60% gross margin next month.

Using the expected volume, we can build an ‘exploded standard cost’ to show the expected total cost by line for the month ahead. (Per unit standard costs x expected volume)

Standard Cost ‘Exploded’ for Volume

Standard Cost ‘Exploded’ for Volume

On the last day of the month, you give Bernard a call to check in and see how the month went. He tells you the following:

“Good news. We hit the sales target of 100,000 units. And I’m pretty sure we hit our gross margin of 60%. Although I won’t know for sure until next week when the books have been closed. The good news is we saved some money by using cheaper buckles, which meant I was even able to afford some discounts for customers.”

Certainly sounds under control.

Five days later you get your first look at the actual income statement for the month (yes, you close the month in five days because you are a boss).

But you are surprised by what you see. 

Volumes were in line with plans at 100,000, and yes the gross margin was indeed 60% (in line). But there is far more going on in the income statement than Bernard’s quick ‘flash update’ suggested.

Here it is:

Actual vs Standard P&L for Belts

Actual vs Standard P&L for Belts

Now here’s where the standard costing comes into its own.

As you dig in further, you find:

  • Due to a global surplus, leather prices crashed by 20% to $0.72 per square inch

  • A procurement cost saving initiative saved $1 per buckle

  • However, due to issues with the new buckle supplier, there was now a 25% wastage on buckles. Meaning the yield had fallen from 100% to just 75%.

  • There were staff turnover issues with leatherworkers. And with less experienced staff, the time taken to produce a belt increased to 24 minutes (2.5 belts per hour)

  • To pick up the slack the supervisors had to increase productivity and work overtime. They increased their throughput rate from 12 belts per hour to 14.1.

  • They weren’t happy about it though. You had to increase their hourly rate from $96 to $110. Otherwise, they would have walked out.

  • And as they were spending less time supervising quality per belt, some inventory had to be discounted due to quality issues

  • Geopolitical chaos sent energy prices spiraling. Variable production overheads were $7 per unit rather than $5.

Now you can conduct a variance analysis of the different components of the bill of materials broken down between $/rate impacts and efficiency/usage-based impacts.

Here’s how:

Reconciliation of Actual Costs to Standard Bill of Materials

Reconciliation of Actual Costs to Standard Bill of Materials

So, turns out, Bernard’s narrative of a business well under control and delivering both its planned volume and gross margin, was true in strict fact. But it certainly didn’t reflect the full reality of the month’s performance

Now we’ve isolated the impacts by line, between rate and usage, we can tell a story on the performance.

Let’s build a simpler picture of gross margin performance vs. plan:

Full Gross Margin Variance Bridge

Full Gross Margin Variance Bridge

And now we can tell the full story.

Yes, the belt business hit its volume and margin target, but there is much more going on in the detail than just that:

  • The procurement initiative to save 10% of buckle costs was a disaster, resulting in 25% waste and costing a net $200k

  • Major labor issues cost $300k between inefficiencies caused by a high turnover in leather workers and overtime paid to supervisors

  • Energy costs spiked $200k

  • Due to quality issues Bernard had to give $250k of discounts to customers

  • All of the above has been funded by a massive (positive) ‘purchase price variance’ on leather costs. Caused by a commodity price change beyond the control of the business

Put bluntly, the things inside Bernard’s control have not been well managed, and it’s only because of a stroke of good fortune in the commodity markets that the margin performance was not a disaster.

This has predictive value. If the leather prices spring back to normal levels, and Bernard doesn’t deal with the controllable issues, the income statement look terrible next month.

Extrapolating Standard Costings & ERPs

This was a simple example. Now imagine if we overlaid a sales volume variance.

Not to mention, this is a ‘one product’ analysis with a small bill of materials. Standard cost cards for some businesses included hundreds of materials and 5-10 different labor rates.

Now imagine that multiplied for a business with hundreds or thousands of products.

This is where ERP systems come into their own. For example, if you sold hundreds of different leather products. Each with its own standard cost card. And leather was a component in every single one, the price impact of a movement in leather costs could be aggregated into a single ‘purchase price variance.’ Your leather buyer can then be measured on the performance of the purchase price for that particular material en masse.

Powerful stuff.

Standard costing accounting originated in manufacturing environments. But it works in service industries and people-based businesses too.

Even if standard costing is not the exact mechanic, an effective CFO should ensure a business can analyze its variances at the lowest level of detail possible. Regardless of the industry.

It’s about measuring the drivers specific to your business.

Dangers of Standard Costing

Used incorrectly standard costings can build complacency. After twelve months of taking heat for missing his yield targets, Bernard could be tempted to re-cost his products based on a lower yield. Or higher input prices. Building inefficiency and ‘fat’ into the costings.

I often see this go unchallenged by finance teams (in the name of prudence). That is poor practice. To avoid complacency, standard costs need a zero base review at least once per year. You can use the budget to provide for performance risks versus standard costs if necessary. You do not want ‘contingency’ built into every product. It makes a business weak and lazy.

Here is an interesting story of how SpaceX used a measure called the ‘idiot index’ to rip out years of fat and inefficiency built into standard costs in the aerospace industry.

The Power of Standard Costing

Great businesses understand P&L variances in the greatest possible detail. Relentlessly ‘attacking the reds’ and never get complacent about the greens.

The more you can break down a business performance, and shorten the feedback loops, the more you understand what is happening in your business.

This is how you make sure those nice shiny break-even charts you created in a spreadsheet, actually make their way to reality on the shop floor.

And that’s unit economics


This series was fun to write.

We’ll definitely revisit this topic again. There’s so much more we can cover.

Next week, we’ll get into CFO economics. That’s right, our 2024 comp survey drops!

Bottom
Bottom Line SCFO

  1. Good finance teams break down variances in enormous detail. The real truth rarely lies at the surface.

  2. Standard costing is one great tool for doing this at an incredible scale

  3. Short-interval performance control is vital for ensuring your planned unit economics become a reality

Office

Operational Rather than Accounting-Focused CFO from Ohio, USA asked:

I recently started my 4th MM PE CFO role. I walked into a company that's distressed but will feel an additional equity injection shortly. In the first week, I've come to realize the current finance/accounting department is incredibly compliance and accounting-driven rather than business or data-driven.

Example: in my first 1:1 with the Corp Controller we spent 3x the amount of time discussing internal controls and the effects of more efficient process changes on them than how the company makes money and how to support our operating partners in doing so.

I want and need a good controller and accounting team to lean on so I can focus on driving the business. That said, I need to move their focus out of that mindset while maintaining their quality work, not steam-rolling them or turning them off during a time of change. I've typically inherited incompetent teams in prior roles, which isn't the case here. It's a matter of moving focus and tweaking the culture. Any suggested approaches to enact this change?

Thanks. Sounds like an interesting role 


The question I would have is how much time you have to make the change and how important it is? Once people reach the controller level there are two things to know about changing their behavior:

  • They will change slowly

  • They won’t change that much

So I think expecting your accounting and reporting team to transform into a super business-focused analytics team overnight is a pipe dream.

It depends on your structure/budget, but my instinct is that you would be better off adding an FP&A resource to support you with driving the business.

Let your accounting and reporting function focus on doing a great job in that field AND supplying the right information to you/FP&A.

If you don’t have the resources for that, then ask yourself whether you can release any budget through a restructuring of your accounting and reporting team. AI & offshoring do present an opportunity to reduce cost, and in many cases, improve quality.

In the meantime, it sounds like you are going to get your hands dirty,

Good luck my friend.

If you would like to submit a question, please fill out this form.

Footnotes

And Finally

Next week we’ll unveil the results of the 2024 comp survey.

If you enjoyed today’s content, don’t forget to check out this week’s sponsor Orb.

Stay crispy,

The Secret CFO

Disclaimer: I am not your accountant, investment advisor, tax advisor, lawyer, CFO, director, or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. And certainly is not investment advice. Running the finances for a company is serious business, and you should take the proper advice you need.

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