The Industrial Profits Puzzle

Understanding the Financials of Your Industrial Business

Industrial businesses are fundamentally rooted in old-world principles, and an old-world mentality in business administration is essential. A focus on profitability is at the core of these businesses. While capital requirements are high, capital risks can be manageable if you understand the fundamentals well.

1.) COGS: The cost of goods sold (COGS) is simply the direct costs of materials that go into the product. The key is to focus on COGS as a percentage of revenue. Industrial companies often forget that product pricing is the biggest lever influencing this ratio. Two critical aspects to focus on are the cost of materials and whether you can price your products appropriately to cover these costs. My experience suggests that you want this ratio to be well below 50% of total revenue, including ongoing inventory. In metal fabrication, for instance, a ratio south of 40% is often the upper limit of the safe zone.

2.) Indirect Labor Spend: A critical amount of indirect labor costs is necessary to provide the required service level in your market. It’s important to ensure sufficient revenue volume to absorb these costs effectively. I’ve found my ratio is 6-12 times the revenue for the burdened labor costs incurred. Here’s a practical example: If you need an engineer, a project manager, a salesperson, and a manufacturing process specialist, this could cost around $500K annually. If these roles aren’t generating at least $3MM-$4MM of direct revenue, you’re creating a recipe for disaster. I’ve often seen companies heavily invest in ambitious projects without critically evaluating the revenue sources needed to sustain these activities. Sometimes, the right team might chase the wrong problem or an unviable market opportunity. Understanding this relationship and making decisions that support profitability is crucial.

3.) Direct Labor Spend: Direct labor refers to the people directly involved in transforming COGS into products. Generally, it’s best if this fully burdened cost ratio is below 15%. Anything much higher, and your business is on the road to financial disaster. This issue is essentially a math problem, as I will explain formulaically later in this post.

4.) Other Fixed and Variable Overhead: This combined ratio should run below 15% in the business. These expenses include normal operating expenses (opex), facilities, Selling, General, and Administrative expenses (SG&A), and related costs like utilities, insurances, rent/mortgages, and selling expenses, among others. In practical terms, this means operating in cost-effective locales, utilizing space effectively, and preventing administrative costs from escalating without checks.

Here’s the formula:

Profit Margin = Revenue - COGs - Indirect Labor - Direct Labor - Other Overhead.

With the ratios I described, these bounds look like:

100% - 50% - 17% - 15% - 15% = 3% Return on Sales (ROS)

This margin is hardly exciting and quite risky, akin to only making money 7-8 working days each year.

Running more optimized:

100% - 35% - 9% - 10% - 8% = 38% ROS

This scenario is more exhilarating, resembling earning significant profits for more than a third of the year. It’s much safer, more lucrative, and creates a better operating environment with funds available for future investments, people, and shared success.

I hope this has been helpful in your journey as an industrialist!

-David