The MIR can be a powerful and fast way to evaluate your next business case. Be aware of potential false precision potholes that you may encounter
It was a cold Saturday morning and Jack Frost was pondering about the interview he had on Friday with Sally Bigsales. Jack liked using his Saturday morning for what he called working on the business.
Sally was most impressive and the time has come to grow again there has been a period of stagnation within the business and Sally could just be the required medicine
Sally articulated he plan that looked most achievable with an expectation to get an additional $1.5M in revenue
To determine Sally’s benefit case Jack deploys the Marginal Income Ratio (MIR) tool.
As a way of a quick introduction.
MIR is the contribution to operating profit based on the next revenue dollar or the dollar growth that you are anticipating in your business.
MIR is also used to determine the Break-Even Sales (BES) that are required to cover the fixed costs and make no profit.
Jack extracted a summary income statement for the last 12 months. To do this he defines his variable and fixed costs.
Variable costs are those costs that vary in direct proportion to revenue changes. Commission paid to salespeople are a good example of this. In Jack’s case, his variable costs were to a third-party warehouse that performed his shipping and logistical functions.
Keep in mind costs don’t behave the way you classify them they behave the way you manage them.
Jack was reasonably proud of his accomplishments with operating profit (EBITDA) at 9% on his total $12M of revenue.
To define his MIR Jack isolated the variable costs and deducted these costs from revenue. This delivered what Jack called his Marginal Income (MI). Representing the contribution before to his fixed costs and required profit.
The next step is to determine his fixed costs. Jack wanted to know the “cost base” that his marginal income had to cover. This included his fixed costs plus the current profit that he was achieving.
Jack knew that Sally would costs him a base of $80K to deliver the additional $1.5M in revenue.
The next step was to determine the new cost base with the know information. This was relatively easy starting with the existing fixed costs he added the additional cost for Sally plus his achieved profit.
Jack pondered on what his expectations were if Sally was to deliver her required sales. His thought process was that he at least wanted to see a 10% growth in operating profit.
With all of this in mind the revised cost base was now $2.498M. The new revenue to produce cover this costs base (fixed costs plus required profit) was close to $13M simply calculated by dividing the MIR into the cost base.
The additional revenue required to achieve the goal is close to $1M. Knowing that Sally plan should deliver $1.5M Jack gut feel was now been supported with sound evidence.
Jack thought about the guys at the Science of Business wealth and smiled, what did they always tell me “Passion for intuition Powered by evidence”. This is what working on your business is all about.
What Jack did not realize is that he was potentially falling into the what we call the false precision trap
Jack being a conservative fellow stress tested his revenue capabilities going forward combining his expectation of what his current business growth and Sally new revenue would look like
The total estimated revenue growth would be $2.7M with the required growth to cover his additional profit and Sally’s costs to be close to $1M. Why would this not work Jack thought.
He quickly computed what the income statement would look like based on the minimum required revenue
Jack smiled with $13M in revenue I can deliver an EBITA of $1.188M giving me my additional 10% profit growth and the possibility is that I can easily exceed that revenue going forward.
As the story goes a year later in the traditional Saturday working on the business session Jack reviewed his results. The following income statement lay before him.
Jack knew things we not going as well as he thought but he did monitor the revenue growth and that was going to plan and thus over time he believed it would get better.
Now that the full trading year had passed Jack wanted to gain insight on the results. Looking at the bottom line first (isn’t that what we all do) Jack looked into his cup of coffee and thought that it needed something stronger than pure coffee in it.
Jack pondered. I know I am all over my costs and they have not increased, I can also see that my gross profit margins have declined slightly but that could not be the reason for this relatively disappointing result.
What happened with all this revenue I am making less money
Jack did a side by side comparison with the previous year showing how the additional revenue impacted his profit.
It was most disappointing to see the additional revenue of $2.7M delivering $148K less in profits, all that work for basically nothing.
But what puzzled Jack was the additional margin. $87k additional margin on $2.7M additional revenue computes to a little over 3% margin. There was no way that Sally or anyone delivered their revenue at those margins.
What happened. Sally introduced a new customer loyalty program that provided her customers with a 10% discount. Jack had authorized this program and thought it was quite innovative. His previous policy was to sell value not price. The success that Sally brought to the business was impressive. This tactic was quickly adopted by the other sales people and the new customer loyalty program over time became a standard offering. The result was not that impressive.
What was originally intended to bring in new customers became the standard behavior for the other sales people.
At the end of the day the average discount amounted to a little over 5%. This translated to a net deficit in operating profit of $148K.
What is the moral of the story we call this false precision as Jack did the right calculations. He even stress tested his ability to attain the additional revenue what Jack did not do was stress test his MIR.
IF Jack at the time of deciding on the Sally strategy said what if my marginal income ratio declines. At what level do I need to ensure that this ratio does not fall below to still provide me with the profit that I require.
If Jack had done this his focus on margin management might have been very different.
Jack weekly scorecard now reflects the average margin percentage that he is attaining.
In summary, the MIR tool is an effective way to assess a business case. The key pitfalls that need to be looked at must include.
- The additional revenue safety cushion.
- The sensitivity to changes in the marginal income ratio
- What would happen if costs behave differently than expected.