Direct Margin Is Where It’s At

It's December 1990 and a young business major sits on a cold stone bench outside the stately doors of his university’s business school building. He had just completed one of the toughest final exams of his academic career—one he most certainly failed. The anxiety is gone, replaced with an overwhelming sense of failure. Stomach in knots, dreams of graduating on time from a respected business school in jeopardy. Elbows balanced just above his knees, forehead buried in the palms of his hands, he mutters, “Cost accounting makes no sense.”

He is not alone. Brilliant accounting students at the finest universities in the world struggle to understand the concepts of cost accounting. Why? Because it doesn’t make sense. Maybe it does to the bean counters who have studied its concepts for years, but to everyone else, it is totally unintuitive.

Overhead unapplied, absorption costing, first-stage allocations. Who thinks that way?

The young man did end up graduating, and earned a CPA license. But my opinion about cost accounting has not changed. It still makes no sense. Not that it’s illogical. I get it now; I can review a cost-accounting-based income statement and understand it. But, cost accounting is confusing, is of little value for making business decisions and can, in fact, lead to poor ones.

 So if cost accounting doesn’t make sense to a CPA, how will it ever be sensible to the team on the shop floor that makes the difference between winning and losing?

Years ago, I came up with this radical idea that people on the finishing team (supervisors, chemists, maintenance managers and the like) should understand the income statement and what it tells us, so I spent time trying to educate them on how the income statement works.

Before long, we were bogged down in a discussion about fixed costs allocations. How much of the accounting department’s time should be allocated to the zinc plating rack line? Why were the salaries paid to human resources allocated more heavily to the powder coating division than to the e-coat division? How did we arrive at the “burden rate” used in determining piece price?

And on and on.

What quickly became apparent to me was that we were getting involved in debates that really had nothing to do with true product cost or coatings productivity. In the end, what difference does it make to the finishing cell supervisor how the HR coordinator’s salary is allocated? None.

More than a decade ago, a mentor introduced me to another, better, much simpler and understandable way of tracking manufacturing performance: direct margin.

The direct margin model subtracts truly direct costs from revenue to arrive at direct margin. No burden, no complicated allocations, no driving up our pricing models in an effort to absorb a bunch of overhead. Just revenue minus direct costs.

Direct costs include labor directly attributable to coatings: rackers, unrackers, powder gun operators and the like. They also include powder, paint, wash chemistry and pretreatment materials, electricity and natural gas directly consumed by the coatings line.

Everything else goes below the direct margin line. Let the accountants worry about allocating supervision, office electricity, sales commissions, equipment depreciation and so on. Just give the coatings team a snapshot of its true productivity.

It’s not complicated, though expect the accountants to double over in distress. Remember, I am a “recovering accountant” myself, so I get to revile my friends in the accounting department with impunity.

I have had my share of experience in advocating the direct margin approach to accountants, so I can warn you to expect objection. “No,” they will argue, “expenses like our salaries, those of the customer service team and property taxes are true costs, and somebody has to pay for them. We need to allocate them to the cost of the product!”

No, you don’t. Those costs are not a variable in their relationship to sales volume. In the short term, we are stuck with the fixed salaries and expenses we have. Why complicate and muddy the financial results by assigning them to product cost?

“But what about capital equipment and fixed cost additions?” they will protest. “We need to burden the product cost with our complex depreciation models.”

No, you don’t. In my direct costing model, decisions about adding equipment or fixed costs are made based on the answers to two questions: Will what happens if we don’t incur the cost be good or bad for the business? If we make the expenditure, when will the additional direct margin (resulting from additional revenue or reduced direct cost) pay back, and can we live with that period of time?

The answer of whether to incur the expenditure is then abundantly obvious, even without the complicated bean counter models. Direct margin as a percentage of sales will appear high—70 percent or more in many companies—compared with a traditional and highly burdened gross profit model, and this takes some getting used to.

However, once team members get accustomed to measuring the business using direct margin, the benefits are many. Financial performance can be easily explained to any employee, not just the accountants. Product pricing decisions can be made by determining the maximum the market will bear and comparing that to the minimum direct margin percentage we are willing to accept. Leave the complicated allocations to the accountants. For the rest of us, direct margin accounting is easy to understand, is a great tool for making decisions and doesn’t tie my stomach in knots.

To learn more visit American Finishing Resources.