Marginal analysis is useful to highlight managerial issues and decision making. A company can use marginal analysis to evaluate business models. Management can use marginal analysis to track operating profit margins and to see what is driving performance. Companies can also use marginal analysis to determine break-even sales. Marginal analysis is a good tool for companies to use to make decisions on improving performance.
Operating Profit Margin
Operating profit analysis is one of the most basic analysis and decision making tools. A company can use profit margin analysis to evaluate a business model. Operating profit is calculated by subtracting cost of goods sold from sales and then dividing the result by sales. A company can decide if a business model is fundamentally sound by trends in operating profit margins. If operating profit margins are declining over time, the firm must decide to focus on increasing sales, increasing prices or decreasing cost of goods sold.
Contribution Margin and Break-even
Marginal analysis is useful to calculate break-even sales. At the break-even point, profits are zero. Management can figure out the number of units sold to break-even and then what profits will be at different unit sales. Break-even units is calculated by dividing the total fixed costs by the unit contribution margin. For example, if a bar sold beer, with total fixed costs of $10,000 and a contribution margin of $2 ($3 price minus $1 variable cost per unit), the number of beers that the bar needs to sell to break even would be $10,000 divided by $2 = 5,000 beers.
Companies can analyze net margins to benchmark performance year over year and against peers. Net margin is calculated by dividing the net income by sales. Managers can examine if the company's net margin is growing, shrinking or remaining flat. For example, if a company notices a trend that the firm's net margin is declining while sales are increasing, managers can use this information to decide on strategy changes. The company may decide to increase prices or to improve efficiency based on further analysis.
Tips and Tricks
Marginal analysis is a good first step to drive business decisions. Poor margins can act as red flags for areas to concentrate management focus. Managers should examine poor margins, then drill down further to determine the most significant performance drivers of the margins. Companies have limited resources and manpower and therefore should rank performance drivers. By determining which driver can improve margins the most, a company can decide what to focus on. A strong margin can also serve as a benchmark or goal for managers to use to measure success.
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