The Margin. Part IV.

Last post about The Margin I said we make $30 profit on every order. That sounds like total bunk so let me explain. I should have said we would make $30 profit on every order. How could we do that? We could if we didn't have any other expenses.

What are the other expenses? Well, we've included all our variable costs when we calculated the margin. What's left? The pesky fixed costs! Let me show how they affect profit. And, forgive the possible ridiculousness of this, but I'm in a certain mood so I'll explain with nautical pictures.

Imagine it's last summer. August 1st, 2007. We're about to start our fiscal year. We begin the year at break even, neither profitable nor with a loss. Imagine break even as the surface of the sea. Above lies fresh air and profit.

Before we take our first sale we commit ourselves to paying for some things like rent and manager salaries. Since we're going to pay for these things whether we take a sale or not we think of them as "fixed." We call these expenses fixed costs. (Variable costs are the other kinds of costs, the ones we pay only when we take a sale.)

Since we're going to pay fixed costs no matter what we essentially start the first day of our fiscal year with a big loss. The loss is equal to our fixed costs for the year. This year fixed costs were $3.5 million. You can imagine fixed cost like a weight that drops us under sea level. Down, down, down we go, 3.5 million dollars below the break even surface.

How do we get back to the break even surface and, hopefully, above to fresh air and profit? We take sales. Each sale is like a step that lets us get closer to the surface. How fast do we rise? That's where the margin comes in: each step puts us $30 closer to the surface. In other words, each order gives us $30 to pay fixed costs and step closer to break even for the year.

How many sales does it take to get to break even? I'll save you the math.

$3.5 million ÷ $30 profit per order = 116, 667.

That's how many orders we have to take to break even this year. As soon as we take order 116,668, we make our first bit of profit. How much? Well, we know that number now: $30.

The Margin. Part III.

Our margin is 35.71%.

So what? How does that help us decide whether to take one more order? Well, it doesn't. We can't make decisions about percents very easily. We need to turn it from a percent into cold hard cash.

Margin is the amount we make per order. If we multiply margin (percent) times the average value of an order (dollars) we'll get a margin in dollars. For the past couple months our average booked order has been worth over $80. 35.71% x $80 is about $30. That means our margin per order is about $30.

Now we have something to sink our teeth into. When we're faced with a choice of whether or not to take one more order, how do we value the decision? How much does it cost to say "No"?

The answer is it costs $30.

That number has some big implications. A couple examples can help us put it in perspective.

Let's say a customer rings us at 8:45 pm. The phones are closed, we don't answer. They decide to shop elsewhere. We lose the order. How much did we lose? $30.

A customer rings us at 3:30 pm on Wednesday. We can't take the add-on. They go shop elsewhere. How much did we lose? $30.

...

This has been a long trip to get to this number, this measly $30 lesson. I took the time because what I explain next usually is often mind blowing. So hold on to your hats, folks.

First Mind Blowing Lesson
In the bookings example: we could have paid someone $29 to work the extra hour after we're closed, from 8-9pm. If they took at least one order we'd still be ahead. Why? Let me put it this way. If I said, "Give me $29 and in one hour I will give you $30," would you take the offer? All day long!

Second Mind Blowing Lesson
The $30 we lost wasn't income. It was profit. Yeah, you're reading that right. Every order makes us $30 profit.

More on that soon.

The Margin. Part II.

What is our margin at ZMO?

Good question. Or rather, questions. Susan responded to my latte challenge by correctly inquiring, “Which margin do you want? Our plan margin? Our actual margin last closed week of fiscal year? Our margin through the holiday? Today's?”

If that makes you confused, it gets worse. Remember the definition of margin: The money that’s left over after we pay all variable expenses required to get a box out the door. That means margin changes with every box. An example:

Box A has one Ultimate Basket. Price is $200.
Box B has one Gold Label Balsamic. Price is $200.

Box A has over 20 items that need to be picked, checked & placed in a basket.
Box B has one item that gets picked, checked & placed directly in a box.

Looking at production labor alone, it’s clear the variable expenses required to get these two boxes out the door will be different. That means the margin for each order will be different. We'll ship 80,000 boxes this year. Does that mean we have 80,000 margins? In a way, yes. But don't freak out. We have a way around it.

It’s useful to recall our goal here. We’re trying to use margin to decide what the benefit is to shipping one more order. The order is in the future. We don’t know what it is yet. We have to predict it. How can we do that? Why not use an average of what happened in the past? It's probably as good a predictor as anything.

Here’s how to calculate our margin, using costs averaged over the period from August to December 2007. These are the final numbers off our December year-to-date financial statement. The real deal.

38.22% Cost of Goods including food and mistakes, subtracting shipping income
10.62% Direct Labor
1.00 % Payroll Taxes on Direct Labor
6.96 % Operating Overhead including credit card fees, etc.
3.09 % DSE Fees
4.40 % ZSN Fees

64.29% Total of all variable costs

35.71% ...is Our Margin (100% total - 64.29%)

So who guessed closest? The latte goes to Jason who said 42.3%. Congrats. I’ll bring it to you next week.

If anyone would like a try at Latte No. 2, here’s my next pop quiz. You know our margin in percent. What's is our margin in dollars? You pick your average box size. Show your math. One winner, chosen at random from correct entries.

The Margin. Part I.

During the holiday season I spoke to a number of leaders at ZMO about making decisions on the margin. By that I mean: when we're faced with a choice of whether to take and fulfill one more order, how do we value the decision? In other words, how much does it cost to say "No"?

Margin decisions are particularly poignant at the holiday. That's the time of year where customer demand almost always exceeds our capacity. They want more than we can give. For example, we might have orders coming in so fast we could take 8,000 for the Wednesday before Christmas. Yet we can only ship 6,500. But what if we could ship 6,501? How much does it cost to say "No"? Or, put positively, how much would we gain by shipping one more order?

Even though margin decisions are at their most poignant at the holiday, they exist all year round. And they're always important when we're chasing revenue--like now. More about that in a later post. First, let me answer what is our "margin" anyway?

Margin is the money we have left after we pay all variable expenses required to get a box out the door. Variable expenses like what? Food, for one. And direct labor. And then other sniggly things you might not think of. For example, since almost everyone orders with a credit card and the card companies charge us to accept them, credit card fees are a variable cost of doing business for us. Each new order means we need to pay the card company.

Which costs aren't variable at ZMO? Lots of things. Me, for one. Salaried people are not variable costs, we pay them whether we take the next order or not. And rent. And utilities. And so on.

It's useful to bring up an old economics adage at this point. In the long term all costs are variable. When we're thinking about the margin we're not thinking long term. We're only thinking about the next order. What are the costs we pay to take that one order?

Next time. What exactly are our variable costs? What is our margin?

The closest guess to our margin--in dollars or percent--from a non-marketing person wins a Next Door latte on me.