The Impact of Forecasting Improvement on Return on Shareholder Value
John T. Mentzer; Journal of Business Forecasting

Improving Salesforce Forecasting
Mark A. Moon and John T. Mentzer; Journal of Business Forecasting

Benchmarking Sales Forecasting Management
John T. Mentzer, Carol C. Bienstock, and Kenneth B. Kahn; Business Horizons

Using S&OP to Reduce Complexity and Create Value
July 29, 2005, 1pm Eastern, 10am Pacific
Principal Speaker -
Seema Phull, Director, Process and Technology, Enterasys Networks


Sales and Forecasting Management Forum Executive Roundtable,
September 7-9, 2005

Margin Planning is an integral part of many companies planning process. The objective of Margin Planning is to get a clear picture of future margins with a view to predict and improve profitability as plans turn into action.

This article discusses what is at the core of Margin Planning – the margin calculation and how it fits into a decision making process. In so doing, calculating margins correctly can yield great benefits, and – if done incorrectly – can be devastating. To start out, let's begin with a margin calculation that most people are familiar with:

Margin = Price - Cost

Simple though it seems, this margin calculation can the source of much confusion. The controversy is not in the formula itself – the problem is typically what costs to include in the margin calculation: Total (allocated) costs? Variable costs? What are variable costs, anyway?

“Our margin calculations are all over the map. ..This organization needs to get on the same page when it comes of margin calculations. We need a uniform way to calculate margins for everyone.” You may have heard statements like this in your organization. If you do, beware -- this can be a recipe for disaster. Margin calculations must be based on the decisions they support . To illustrate this important point, let's consider margin planning for an airline – an example that applies to your industry as well:

An airline is considering buying a new airplane to serve the market between city A and city B. To evaluate this decision, the airline does cost-benefit analysis over the expected lifetime of the airplane. The resulting margin calculation includes all projected costs – the cost of the airplane, fuel costs, airport costs, labor and so on. Revenue calculations are projected based on average rates in similar markets and average expected utilization. If the total margin calculation (over some period of time) comes out profitable, then the airplane is purchased.

Once the airplane is purchased, the airline has made an irrevocable commitment, and decisions at this point are all about making the most out of this asset. Flight schedules and basic fare structures must be made based on seasonality and other factors. Suppose the market between city A and city B has extremely low demand during some part of the year. To fill the airplane, tickets must be sold at heavy discounts – discounts that are much lower than the average fair assumed in the analysis done to justify the purchase of the airplane. How deep discounts should the airline allow? If the airline used the same margin calculations used in the analysis of whether or not to purchase the airplane, the discounts would likely be small (if any), and the airplane would likely not be scheduled to fly. But costs would not go down accordingly – the cost of paying back the airplane would still be there, resulting in huge losses. In this case, any fare that contributes to paying fixed costs would be better than the alternative. This means that the margin calculation should be based on the variable costs of operating the airline.

Does this mean that all pricing decisions should be based on this “rock bottom” margin calculation? Not at all. In most competitive industries prices are determined by what the market is willing to pay, and companies must conform to that price. Margin Planning helps determine what the “rock bottom” price can be, not what the selling price should be. Hopefully, over the course of a quarter or year – the average price will amount to total revenues that equal (or exceed) the assumptions set forth in the strategic analysis.

So the airline makes a decision to schedule the plane also in the low season. With this decision the airline has committed labor costs, fuel costs and airport costs. Then, one week before a particular departure, the plane is half-full. A group calls to negotiate fares. How deep should the airline discount to take on this group? At this point most of the costs are already committed – everything except ticket handling and meals. The rock-bottom fare at this decision point would be a fare that covers these costs and contributes to some portion of the fuel, labor and other (at this point) fixed costs. Again, had the airline used either of the margin assumptions applied above, the group would likely not have filled up the airplane.

Taking a step back, the above example illustrated how margin calculations change based on the decision at hand – from strategic decisions, to tactical decisions, to operational decisions. For strategic decisions, just about every cost is “up for grabs”, and should be accounted for in the margin calculation. It is this margin that determines whether the company will be in business 5 years from now. At the tactical level, decisions are about making the best out of existing resources months to a year out in time, and at the operational level – weeks or days. As we also saw above, the correct way to calculate margin is using variable costs, which again depends on the decision at hand .

Margin = Price – Variable Cost



Does this apply to manufacturing? Yes, it does:

Strategic decisions are about committing resources to offer products to specific markets or regions, and what channels to sell through. Decisions at this level must be made with a product lifecycle view in mind, and resources can be committed based on whether or not the corporation will be more profitable, all costs accounted for.

At the tactical level, decisions are made about offering those products in given quantities and prices, and managing accounts. Seasonal variations and specific customer relationships must be taken into account when determining discounts, quantity rebates and so on. If the full cost of each product was the deciding factor in this analysis, few discounts would be offered and (likely) much business lost.

At the operational level it is all about fulfilling those commitments and deliver on time, making decisions about what customer requests to reject, put on backlog, whether or not to use overtime to improve customer service, etc.

Conclusions

This article provides a primer on how to calculate margins in Margin Planning. Margin is calculated as Revenue – Variable Costs. What constitutes variable costs, however, depends on the decision at hand:

• For strategic decisions, most costs are variable.
• At the tactical level, there are considerable variable costs, but decisions should not be constrained by costs committed at the strategic level.
• At the operational level it is all about delivery and customer service. Here, most costs are fixed.

Understanding your variable costs in context to the decision at hand is paramount to improving profitability in Margin Planning.