Getting Back to Basics

November 13, 2023

Let’s discuss some of the key financial and operational relationships that are universal to almost all converters, how to measure them in your operation, and what modifications you may wish to make to your accounting, plant performance measurement, and financial reporting systems to properly highlight and analyze them.

Material Margin

The key relationship in the financial statement of a converter is material margin, yet most financial statements that I see do not focus on this relationship. Instead, I often see gross profit or contribution margin as the ultimate measure of margin before operating expenses. Although these measurements can certainly be important, it is usually best to look at the overall relationship between materials and sales, since this will be anywhere from 40% to 70% of the expenses of the company. When labor, overhead, freight, and other costs are included in the calculation of margin, material margin may be partially obscured by efficiencies or inefficiencies in these other areas.

In evaluating this key relationship, it is also important to make sure of the following:

Your reported sales and reported materials at the top of the statement relate to manufacturing of converted goods. To whatever extent you mix in the sale of purchased products, packaging supplies, tooling, waste, labor-only sales, and other miscellaneous items, the relationship between paper or board purchased to converted sales becomes distorted.
Brokered sales of converted and nonconverted products should be shown separately and matched up with their material costs.
Purchased products that are ultimately billed as part of a manufactured sale should be shown as part of manufactured materials, since that is where the billing will be done. If you put a purchased product in the same general ledger account, or the same financial statement grouping that is matched up against purely brokered sales, the resulting margin will be skewed as will the margin on the manufactured sales.
The sale of tooling should be matched up with the purchase of tooling, and replacement tooling that is not being billed should be shown separately so the markup on tooling can be readily seen in the statement.
When labor is the material income producing factor such as in assembly and pack out areas, that labor should be broken out from regular plant labor and matched up against that revenue.
Waste measurements should also be made and noted on the financial statements to help evaluate the efficiency of material usage.
Finally, some stratification of converted sales by style, machine routings, or graphic content should be included as a sub schedule along with information about the associated margin.

Typically, income statements follow these formats:

Sales less cost of goods sold = Gross margin

or

Sales less direct costs = Contribution less indirect costs = Gross margin

My recommendation is that you utilize the following:

Converted sales less converted materials = Converted material margin plus material margin from brokered and other items = Total material margin less labor, overhead, and delivery = Gross margin

This has the effect of segregating the margin generated from manufacturing from the margin generated from other endeavors, which is important because of the capital intensive nature of converting operations. Much of your invested capital is in the manufacturing plant and equipment, and therefore, it is important to segregate manufactured results on the income statement. At the end of the day, the key to profitability in a manufacturing environment is to generate enough margin to cover your fixed costs and generate a return on your investment. By treating materials as the one true variable cost in your operation and separating manufactured margin from nonmanufactured margin, it will be easier to understand the profitability—or lack thereof—of your operation.

Major Machine Hours and Efficiencies

After material margin, the second most important statistics in a converter’s financial statements are machine utilization and efficiencies, yet this data is generally not found on your financial statements. In general, when your machine utilization is high, you make money, and when your utilization is high and your efficiency is high, you make a lot of money. Of course, all of this assumes that your markups on materials are high as well, which is why the first part of this article focuses on material margins. High margins can overcome a lot of inefficiencies but not an overall lack of orders.

Almost every piece of converting equipment carries a multimillion-dollar price tag, and that is before stackers, pre-feeders, and the required conveyorization. Filling your machines with profitable orders is the main job of the overall sales effort, and producing them quickly, efficiently, and without defect is the main overall job of the production effort. For those of us in the measurement business, understanding these relationships and measuring them are consistent and objective matters, while making the results understandable is at the core of our mission. But where is any of the machine information that is integral to understanding profitability shown on your financial statements?

The answer, of course, is nowhere. Financial statements generally only contain purely financial information that comes from your general ledger and is vetted by detailed reconciliations of cash, receivables, payables, inventory, and payroll. But without some operational information, can it tell the complete story of the company’s profitability? On the other hand, if you bring too much nonfinancial information into the reporting, will it make the information more cumbersome and difficult to understand? A certain delicate balance must be maintained, but if margin versus fixed costs are the key to measuring profitability and machine utilization and if efficiency is the key to understanding profitability, then they should both be accommodated in the efforts to measure results.

The answer is by utilizing sub schedules and possibly bringing some summary information onto the face of the income statement. Just by noting the number of major machine hours run and the percentage of overall capacity this represents, each reporting period next to the margin generated enhances the reporting. Adding a sub schedule that shows the hours run by each major piece of equipment and the percentage of that machine center’s capacity will go a long way toward explaining changes in margin from period to period.

So, keep your sales and material buckets clean in your general ledger and create a focus on manufactured versus nonmanufactured sales. Add some sales analysis and machine hour reporting to the mix, and you will have taken the first step toward enhancing your reporting systems. Over the next few BoxScore issues, I will focus on other areas where reporting can be streamlined and improved and other operational data that can and should be incorporated into your financial reporting systems.