Whenever a business is looking to increase production, incremental net income margins become an important factor. Knowing these numbers will determine if you will be making money or losing money based on the changes you make to your products or services.
TL;DR (Too Long; Didn't Read)
To calculate incremental net income margin, subtract additional production costs from the revenue you will get from making additional products.
Calculating Gross Margins
The margins for your business represent how much money you make from selling your products or services after you take into account your costs. Gross profit is your revenue for a period, minus the costs of goods sold. Gross margin is your gross profit divided by revenue.
As a basic example, suppose you make wooden rocking chairs, which you sell for $200. The cost of the wood and labor is $120, leaving you with $80 gross profit. Your gross margin is profit/revenue, or $80/$200, which gives you a 40% gross margin.
Calculating Net Margins
Net margins, or operating margins, include production costs plus overhead for your business (i.e. operating expenses). Overhead includes things like lease payments, equipment costs, insurance, utilities and salaries for people who don't produce the products. These are generally fixed expenses that don't change each month.
Let's assume you make the chairs yourself in your garage, so your overhead costs are low, working out to a mere $40 per month to account for the cost of your tools, the cost to keep a light on and to pay for a small heater you turn on in the winter.
In this case, if you only made one rocking chair per month, the cost of production plus overhead is $160. This gives you an operating profit of $40, or an operating margin of 20%.
Incremental margins are the profit you make from selling an incremental unit of a product or service. Suppose you decided to put some extra effort into your business and make two rocking chairs each month instead of one. Because your overhead costs won't go up just because you're making another rocking chair, the margin for this chair is the same as your gross margin on the first one was: $80 incremental profit, or 40% incremental margin.
In a more realistic example, a profitable business would be making many rocking chairs, not just one, and the costs would be more complex. So let's turn this rocking chair hobby into a business, with two employees and a cheap building you found on the edge of town.
- Production: 100 rocking chairs each month
- Revenue: $20,000 each month ($200 per chair)
- Materials cost $4,000 ($40 per chair)
- Labor cost: $4,000 ($40 per chair)
- Overhead expenses $4,000 ($40 per chair)
Now your net profit margin is 40%, or $8,000 per month. If you wanted to make an additional chair by the end of the month, you would only have to factor in the cost of material, as your labor cost would remain the same for such a small increase in production. Your incremental net margin for one extra chair is then 80%, or $160, which is not too bad at all.
Incremental Break-Even Analysis
Now that your rocking chair business has become very successful, you get a call from a large furniture retailer wanting to buy 50 chairs every month, but they want a discount. They offer you $100 per chair. Before you accept their offer you need to know if this is going to make you money or cost you money at the end of each month. To answer this question, you should do an incremental break-even analysis.
For this number of chairs, you will have to hire an additional worker, but your other costs will remain the same:
- Production: 50 extra rocking chairs a month
- Revenue: $5,000 each month ($100 per chair)
- Materials cost $2,000 ($40 per chair)
- Labor cost: $2,000 ($40 per chair)
- Overhead expenses do not increase
Adding the materials and labor together, you have a total cost of $4,000 and so your incremental margin for these extra chairs is $1,000, or 20%.
To do a break-even analysis, divide the additional production units (50) by your costs. In this case, the incremental break-even point is $80. If the retailer had offered you $79, you would be losing money, but anything above $80 means you are making money.
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