Knowledge base
Coverage margins
Coverage margins
30.05.2016

Piotr Ukowski

How do we determine how much money we make and what we make it on? Do we need advanced tools to calculate the margin?

On the surface, in the colloquial meaning, everything seems easy. A margin is the difference between the price (of sales) and (prime) cost. However, this would be too easy; the concept of margin is used in many different areas. The most common is retail margin, determining the difference between the goods’ purchase price and the sales price. In this context, the percentage margin is often used, which is calculated in relation to the purchase price or sales price.

Knowledge base

The gross margin determines the contribution of a given product, goods or service to the coverage of fixed costs and to generating the financial result of the enterprise. Hence, it is often referred to as the coverage margin which determines the scope in which the sale covers the costs.

The concept of costs appears in all the aforementioned cases. It is of key importance for calculating any type of margin. Of course, calculation of the retail margin where the cost is the price of purchase is the simplest; however, this type of margin in actual analytics of an enterprise's activities becomes insufficient.

The analysis of coverage margins is based on the control of the range of costs used for its calculation. Depending on this range, we distinguish further grades of coverage margin. There is a considerable arbitrariness here and the cost accounting is adapted to the specificity of the enterprise. Grading may be different for manufacturing and trading companies, acting directly and through resellers, etc.

1st-grade coverage margin

If, for calculating the coverage margin, we only take direct variable costs associated with a product/ goods, we are dealing with 1st-grade margin. It determines the extent to which the sale covers acquisition costs (purchase, production) and what measures it provides to meet the enterprise's constant and overall needs.

Analysis of 1st-grade margin shows, first and foremost, whether we directly add money to the sales. It can also be used to calculate the break-even point, at which production volume it becomes profitable.

2nd-grade coverage margin

At the 2nd level, we add to the analysis the expenses incurred for promotion and sales of the product. These are also variable costs, depending on the volume of sales, but not necessarily linearly. They include costs of transport of a given product range, costs of discounts, promotions and agreements with customers (e.g. the costs of preparing a brochure for a hypermarket) as well as the costs of customer service – returns, complaints. Entering this additional information lets you see what effect the following have on the margin: sales channel, methods of reaching Customers, and whether the promotion costs do not make the product unprofitable.

Already at this point, the analysis of coverage margin may pose problems. How do we break down the marketing costs? How do we calculate the direct costs of transport, if we used one “HGV” to transport dozens of goods to many locations? We will discuss it a little bit later…

3rd-grade coverage margin

The more you get into it, the more complicated it becomes... Goods and services do not sell themselves – the 3rd-grade margin additionally takes into account the prime costs of the sales department. Traders, their cars, telephones, representation costs, etc. are often a significant cost load. Thanks to 3rd-grade coverage margin, we may determine what activity is most burdensome for our sales department. At this point, we have to take into account the fact that selling different goods costs differently – some of them are sold almost automatically, to “get rid of” others one needs to work hard (and spend money).

4th-grade coverage margin

The highest level (presented in this example, as I have already mentioned, depending on the specifics and above all on the needs of the enterprise; introducing a different granularity for analyzing coverage margin may be justified) determines the extent to which the product/ goods/ service affects the profit of an enterprise. The costs of general management should be included in the above-mentioned costs – managing board, administration, accounting and staff costs, etc. Only such an advanced analysis lets us determine the real profitability of particular activities and products.

Here we are apparently entering the area of various breakdowns and models allowing us to break down the costs in the simplest and most realistic way.

Models, breakdowns, controlling methods

Analysis of coverage margins consists in a good analysis of costs and advanced endorsement. In principle, we deal with their simple direct allocation to goods/services only at the 1st level. Just one step further, we encounter “common cost sacks” in which the reporting accumulates, calculates and sums up the expenses. The fact that the machine is amortized with one amount a month does not mean that we produce only one product on it; a salary of the chief accountant and of the chairperson of the company also affects the 4th-grade margins to a varying degree, etc.

Tools for breaking down costs and for constructing models are also useul. Often such operations are tediously prepared in Excel, and calculated for reliable results. Such a solution has a number of drawbacks: it is usually difficult to obtain general methods, possible to reuse, it is difficult to use the results in other analyses, and labor intensity and complexity require great skill. The results themselves constitute only a report and not a source for further analytical works outside the financial department, and this is the biggest problem. To know “how it is” is only half way to success, you still need to know “how to change” to be better ...

What instead of a spreadsheet?

The answer is tools for data modeling, e.g. manufactured by INTENSE GROUP . The point is that the financial controller performs the work that can be used by e.g. the commercial director. By using controlling expertise (Activity Based Costing method is essentially necessary here) and advanced tools, they break down the costs so that they become the source data for subsequent analyses. Then, models can be built which answer questions such as: how will introducing a promotion affect the profitability of sales; how will extending a production series affect flexibility, affect products and demand for storage space; how does direct marketing change costs on goods, etc.

Should you do it and how?

Analysis of higher-grade coverage margins is a big challenge. However, with declining margins, it often becomes a significant element of building a competitive advantage. Detailed cost analysis generates high organizational requirements – selecting the right enterprise structure (profit centers), designing workflow, implementing analytical endorsement at the right level (breakdowns). I’ll discuss it another time…