Running a profitable manufacturing or distribution business is not for the faint of heart. As the person in charge, you’re expected to control costs, manage inventory, keep an eye on cash flow, and minimize taxes — all while driving sales and keeping up with the latest technology and legislative changes. Now add in reading and interpreting dense financial statements. Where do you even begin?!
Key financial metrics all manufacturing businesses should be using to evaluate the financial health of their organization.
Cost Metrics
Cost of Goods Sold (COGS) = Beginning inventory + purchases – ending inventory
These are the costs of manufacturing the products sold by the company. This amount will include any direct materials and labor used in the manufacturing process as well as indirect costs of overhead, distribution, and sales force labor. These are all costs that are tied to the production of goods/services.
Gross Profit = Net Sales – COGS
This metric looks at the production costs of the manufacturing business versus the general and administrative costs. Looking at Gross Profit can help a business determine how well a company is managing its production, labor cost, and raw materials in its manufacturing process.
Inventory Metrics
Inventory management can be critical for manufacturers to understand how long inventory is sitting in a warehouse and if a company can fulfill incoming orders. It also reflects the length of time that cash is tied up in inventory before being converted back to cash.
Inventory Days = (Avg. Inventory/COGS) x 365 days
This metric helps to show how much inventory a manufacturing business has on hand on any given day. It can demonstrate how quickly the company responds to market and/or product changes. Inventory Days indicate the average number of days it takes to convert inventory into sales. If this number is high, it could indicate certain inventory that is not moving or is harder to sell.
Inventory Turnover = COGS / Avg Value of Inventory
Inventory Turnover can help a manufacturer assess how well it is using the company assets, and it also indicates how often inventory is sold and the number of times inventory is sold and then replaced, within a specific period. A lower inventory turnover number can be an indicator of weak sales and/or an excess amount of inventory held in the business. Where a higher ratio can imply strong sales and effective inventory restocking. However, this number can be distorted by seasonal factors.
Profitability Metrics
Gross Profit Margin = Gross Profit / Sales
This metric can be handy for manufacturing businesses in understanding their profitability. The Gross Profit Margin explains the percentage of sales revenue that exceeds the costs to produce the products sold (costs of sales). This can be helpful in business planning because it indicates how many cents of gross profit are generated by each dollar of future sales. If the number increases each year, it indicates the business is becoming more efficient. This can help a company determine how efficiently management uses labor and materials in their production process.
Net Profit Margin = Adjusted Net Profit before Taxes / Sales
This measures how many cents of the profit the company is generating for every dollar it sells. Net Profit Margin can be very important when preparing forecasts. The higher this number percentage is the better. This can help to indicate how effectively the business is being run overall.
Operating Profit Margin = Operating Income/ Net Sales
For manufacturing businesses, the Operating Profit Margin can be a valuable tool in evaluating the profitability of the business. This metric measures the percentage of profit a company is making on every dollar of sales before including revenue and expenses incurred outside of operations. Some examples of nonoperating revenue would be a gain on the sale of assets or interest income. Nonoperating expenses could include interest expense or a loss on sales of assets. If this number is high, it indicates that the company is operating efficiently and turning sales into profits. If that number decreases, it may indicate that systems are not operating at their best. This metric can help businesses to see how efficiently the company is running its core operations. This can help the company assess whether they are making the most of their income from operations or another means, like investing.
Cash Flow Metrics
Operating Cash Flow (OCF)
In the manufacturing industry, understanding operating cash flow and what it indicates can be helpful. Operating Cash Flow (OCF) is a calculation to determine the amount of cash that is generated by the company’s normal business operations. The OCF can indicate if the company is generating positive cash flow that maintains the business, allows for expansion of operations, or the ability to pay down debt, or provides for a return on investment for owners. Low operating cash flow can possibly indicate the need for external financing. The OCF can help to determine the success of the company’s core business activities. This calculation can show the reality of the business operations and if there is cash on hand to purchase materials and pay wages or if funding is needed to help the business keep running.
Don’t rely too heavily on Revenue Metrics
While revenue metrics can be helpful, they are not always the best ones to look at for the manufacturing industry. Fluctuations can happen from year to year between different streams of revenue within the business. It can be helpful to look at and understand why one line of revenue has increased/decreased over some time and what influences from outside factors have happened.
The metrics we outlined in this article only scratch the surface of the financial information available to help guide your business. This wealth of information not only illustrates the financial state of your manufacturing business but also when put in the right hands, helps drive strategic decision-making and future success. At Wegner CPAs, our manufacturing advisors are here to help shoulder some of the burden for their clients. If you’re looking for help deciphering your financial statements or finding the right metrics to evaluate your business needs, reach out to one of our experts.
