Lessons Learned: Measuring Profitability. Not that straightforward.
Profitability is a topic which takes the lion’s share of discussions within business environments. “Profitability last year was not as expected, profitability of this new project is not high enough, that product has a negative profitability ” etc. ???
Every CEO, every business development vice president, every business unit head, let alone the CFOs, discuss it with their boss all the time. And even if the overall company’s profitability is the top of the iceberg and it is measured by EBITDA % over revenue, the question remains of how the profitability should be calculated for potential new projects in case they are incorporated into the company’s business i.e., how the new project will affect the company’s bottom line.
Adopting the most representative measurement in the effort to predict the profitability impact of a new project is vital for facilitating managerial decisions that are aligned to the specific CDMO business strategy.
In the CDMO of our story, under the new management, the constant request was to express profitability for every action taken, using EBITDA. But it was clear that defining the right profitability is much more complicated than that. Because for example it doesn’t usually make sense to express profitability of a new business using EBITDA. And the same goes for calculating the profitability that you will lose when a product is discontinued.
But first things, first. To answer to this question, the CDMOs need to determine what costs should be taken into consideration. And in many cases, this is much more complicated than it sounds. Take new business for example. At one extreme, there are CDMOs that add to the cost all direct, fixed costs and overheads of the company (somehow allocated) and at the other extreme there are CDMOs who include only direct costs required for the production of the specific product.
Apart from the direct costs associated with the production of the product (direct labour and direct materials) should we add to the cost part of the equation, fixed costs and overheads? And if yes, which of the fixed costs and overheads? In the above, simplistic example of an imaginary product, is the profitability 50% or 0%? Or maybe 25%?
Is there a golden rule of calculating profitability that fits all CDMOs? If the above figures were the figures of a new product awarded to a CDMO, would this be a profitable business or not? Would the CFO and the Commercial director be happy with this? (if ever Finance and Business development manage to agree on something)
Instead of trying to answer to these questions, let me put some more questions on the table…
Some of the above questions may sound irrelevant to the initial dilemma (i.e. which is the most appropriate way to express profitability), but in reality they are not. In fact, it matters for example if the CDMO belongs to a fund whose goal is to sell the company in the next 3 years in a price that is multiple times of its EBITDA. This is different from a CDMO belonging to a family whose main goal is to increase volumes and revenue. This is because in the first case an increase of 1million in EBITDA will result in 10 million maybe, in the pocket of the fund (due to the fact that they can sell the company 10 times more than its EBITDA) while in the case of a family-owned business, an increase of 1 million in EBITDA will stay as is if there is no vision to sell the company.
Therefore, if this was the only factor affecting the decision of which is the best way to measure profitability (which is not), the CFO of the first CDMO would insist that every new product entering the site, should cover all allocated overhead costs (and generate EBITDA increase with every new product), while the CFO of the second CDMO might be happy if only fixed allocated costs were covered.
But, since the structure of the CDMO is definitely not the only factor affecting the most appropriate way to express profitability, let’s see how other factors contribute to the decision.
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Let’s assume that a pharma company has requested from two different CDMOs to confirm if they can produce product X at a given target price of 100.
Below there are some assumptions for each of the CDMOs. They are extreme and hypothetical cases, for the sake of argument. In reality such cases do not exist, but they are used in a way to explain the rational. (more or less what economists do with monopoly and perfect competition)
In the case of CDMO 1, the new product will not add additional fixed costs, will not require additional investments and its capacity utilization is quite high, meaning that its current fixed costs are already covered. Moreover, the process for CDMO 1 will be 100% manually, meaning that no machinery will be used for the production of the product. Finally, there are small general overheads and the equipment in house is old and therefore already amortized and paid off.
For CDMO 2, everything is opposite.
If both CDMOs have the same direct material and labour cost for this product (let’s say 50), both of them will have a contribution of 50%. (Contribution = Unit Price – Direct Cost). However, CDMO 1 does not need to cover any existing fixed costs (due to the 80% capacity utilization) while CDMO 2 cannot afford to add products in the site if they do not contribute heavily to the fixed cost absorption.
Similarly, CDMO 1 does not have to worry about financing increased fixed costs as well as investments required for this product, while CDMO 2 does. Finally, the fact that the general overheads are low for the CDMO 1, probably means that the salaries of the corporate team have already been covered by the existing products. For the CDMO 2, which is much bigger with higher general overheads and recent investments into equipment made, new products entering the site(s) should not just cover their cost but also heavily contribute to the absorption of general overheads.
Considering the above, CDMO 2 in his profitability calculation should take into account the high fixed costs he has to cover. Hence, a gross profit calculation, that helps him to do so is very much needed. (Gross Profit = Unit Price – Direct Cost – Fixed Cost)
The above extreme example presents two different profitability measurements, Contribution and Gross Profit. If CDMO 1 decides to use purely the Gross Profit measurement, inevitably in his attempt to do so, will allocate part of the fixed costs to every new product that will enter into the site. If for example the CFO sets a target of 20% Gross Profit for every new product, this means that price should be 25% more than the sum of direct and fixed costs of the product. (because if direct and fixed costs equal to 80, a price of 100 would lead to 20% gross profit, but 100 is 25% higher than 80).
However, if fixed costs have already been covered or are zero for new products (in the extreme above example) this will lead to a false cost calculation and wrong profitability figure. There is no point in measuring Gross Profit in this case. Contribution is a much preferable measurement as it focusses on the direct cost and gives a profitability picture much closer to reality.
To put it in another way, if fixed costs do not really change with the addition of new products, Contribution is a more appropriate reference. If on the other hand, CDMO 2 starts measuring Contribution and forget about fixed costs and Gross Profit, it will find himself very soon with a full manufacturing site that probably does not cover its fixed costs.
The same is true not only for new products but also for discontinuations of existing products! If a big volume product is discontinued, its negative effect on the site is much higher than its current Gross Profit, in case fixed costs do not decrease accordingly. Imagine for example that an existing product with annual Gross Profit of €20K and annual Contribution of €50K is discontinued. If fixed costs do not go down (and usually this is the case), the negative impact on profitability is not just the €20K per annum. The Contribution should be measured as a loss in this case (depending also if direct labour costs will be removed or not).
Even more attention should be given to negative Gross Profit products that are discontinued. Let’s assume that a minus €20K Gross Profit product has a positive €30K annual Contribution. If this product is discontinued, the effect that will have in the overall picture of the site (if fixed costs do not go down) will be negative at least by €30K and not positive by €20K.
Of course all of the above were too complicated to be considered by the CDMO of our story, and therefore top management was asking for EBITDA impact, which was what the unrealistic business plan was asking for. Nobody, cared to make the exercise on what will happen to the costs associated with new business or discontinued business and the result was that different departments used their own calculations. What a mess…
In general, keeping an eye to both measurements (gross profit and Contribution) makes sense and there is no golden rule that fits all cases. Neglecting one of them completely is also false.
So, next time that you are about to calculate the impact on profitability of a new product or a product that is about to be discontinued, be careful on what measure you will use. Similarly, when setting targets for profitability of new products, think twice which is the most appropriate measurement for your company. It might sound easier said than done, but it does worth the effort to put some thought on it.?