Materials, People, and Capital

July 7, 2023

When you cut through all of the details associated with financial reporting, you will likely find the three largest items in any set of financial statements for a manufacturing company are materials, personnel costs, and capital expenses.

Materials are generally somewhere from 40% to 60% of the income statement. Aggregating all of your employees’ costs (e.g., salaries, taxes, benefits) will usually be between 20% and 30% of your income statement, and capital costs, when you consider depreciation, equipment, and facilities rental, maintenance, repairs, and interest expense, will be between 10% and 15% of your income statement. Fixed assets and debt are often the largest numbers on your balance sheet. Yet, conventional financial reporting is geared more toward categorizing things by department or function and does not in any meaningful way aggregate items in this manner.

Most business owners get used to a fairly standard set of financial statements developed early in the life of their businesses and are hesitant to make changes. Often, the owners come from the sales or production side of the business and struggle to some extent with finance, and although I hate to admit it, most accountants seem to lack the creativity gene. The typical financial statements I see are mostly a listing of expenses categorized by function (e.g., cost of goods sold, plant, selling, administrative), often with a comparative to a prior period and to a budget.

I’ve written numerous articles over the years about how to improve the basic statements by creating profit centers and cost centers, adding analytics, and bringing other nontraditional performance measurement data into the statements. I have also strongly advocated the use of different reporting formats for the same period—tailored for different areas of management, such as sales, production, and maintenance. One of the formats I like the best for executive management focuses on what I call the big three—materials, people, and capital—because at the end of the day, managing those three key resources is crucial to the success of the enterprise.

Materials

In most cases, it’s not enough to simply look at materials as a percentage of sales. Material margin in the aggregate is the key indicator of profit potential in a converting business, but unless your sales mix is exactly the same from month to month, you need more information.

Sales less materials are often called “throughput dollars” and, in my opinion, the simplest and truest measure of the variable profits of the enterprise. But every converter has different sales categories: single-machine operations, multiple-machine operations, simple print, complex print, hand labor, labels, outsourced items, etc. So, the first order of business is to match the materials up against the sales in each category.

Simply stating that your material margin is 46% is not enough information. Comparing your material margin month by month in each meaningful sales category may tell a completely different story and isolate areas where your company and your pricing decisions are strong or weak. Adding machine hours to this equation and getting a sense of the dollars per hour yielded in each manufactured category will give you even better information. If you aren’t prepared to start looking at the hours, at least start calculating the margin for each category.

Margin information is certainly crucial information, and while this is often predicated mainly on pricing decisions, other factors can influence this in a meaningful way. Remember that each 1% improvement in margin will yield significant dollars on the bottom line, so if you are a company doing $25 million in sales with a 50% material margin, every 1% increase will yield $250,000 in profits. Therefore, it is important to look at things such as:

Waste: What you need to look at here is not baled waste as a percentage of sales, but rather the paper or sheets you paid for but didn’t bill your customers for. This concept is known as shrinkage and something you need to start measuring.
Basis weight: I have attempted to survey this many times over the years and have found that most of you simply don’t know the basis weights of the packaging you are selling. At the end of the day, the heavier the weight of the packaging you sell, the higher the sales price, and thus, the margins should be.
White and mottled white content: Again, more expensive paper or sheets should yield a higher sales price and higher margins.
Inside/outside print and heavy ink coverage: These should yield similarly higher prices and margins.

So, analytics showing material usage by category of sale and these other factors are ultimately the keys to understanding your material margins.

People

Personnel costs are all over your income statement. Cost of goods sold generally includes direct labor, indirect labor, temporary labor, maintenance labor, supervision labor, schedulers, and plant management. Shipping and delivery expenses generally include a shipping manager, material handling personnel, and drivers. Selling expenses generally include salespeople, designers, customer service representatives, coordinators, and departmental managers. General and administrative expenses include everyone else.

Almost all of you employ more than 50 people, and in some of the larger converters, the number may be closer to 250. While it is important to know the cost of each function (e.g., plant labor, design, customer service, maintenance), there is also value in aggregating all of the employees and all of the expenses relating to the employees to give you a sense of the cost of your people and the overall cost of managing them. You should still list them by function and provide head counts and compensation levels, as well as break out overtime and bonuses (and maybe even add some productivity measurements). You also need to make sure all statutory and incentive costs associated with employees are included (e.g., payroll taxes, health insurance, pension contributions, workers’ comp insurance, incentive programs, training programs, travel, seminars) so you can see the full cost of the add-ons.

Capital

How you finance your business varies greatly from company to company. Most of you purchase major pieces of equipment but lease tractors and forklifts. Some of you own your real property, and some of you lease it (often from related family entities). Some of you are well capitalized with relatively small amounts of debt, and some of you are more highly leveraged. Therefore, your capital costs show up in various places on the income statement, so you may not ultimately appreciate the full cost of capital in your company.

Aggregating your capital costs can often give you a different insight into how you are funding your business and what percentage of income or assets relate to capital costs. These costs would include depreciation, lease expense, interest expense, rent expense, and related occupancy and repair costs.

So instead of just publishing the traditional sales less cost of goods sold less operating expense equals operating income statement you normally see, ask your controllers to give you an alternative income statement that shows sales less materials less people costs less capital costs less all other expenses equals operating income. Make sure they add all of the appropriate backup, and I think you will see your business from a different perspective, especially when compared from period to period.