How to Calculate and Use Material Margin to Drive Competitive Pricing
Editor's note: This piece was originally published in 2021 and has been updated to include additional resources.
When determining manufacturing costs and pricing, you can look at a number of different margins to determine efficiency and profit. These metrics often factor in many costs like overhead, labor, and more. Material margins, on the other hand, are a simple metric that can contextualize your manufacturing costs to help you price competitively for your market.
How Material Margin Helps Manufacturers Set Competitive Pricing
Your material margin is essentially the money you have to work with after you buy the materials you need to create a product. Unlike other metrics (gross profit margin, operating margin, or contribution margin), material margin accounts only for the costs of the materials you use and not direct labor, overhead, or any costs other than direct materials.
Material margin is useful because it can help you determine the right price for the right product at the right volume to stay competitive in the marketplace. For example, high-volume jobs typically have less complexity in terms of overhead, so applying overhead using traditional methods could overstate cost and price you out of the market.
If you have excess capacity (idle equipment, no additional labor, or expense outlay), you may be able to take on smaller, more complex jobs, as long as the material margin is high enough to cover fixed costs.
How to Calculate Material Margin
Material margin dollars are revenue less material costs. When calculating your material margin and material margin percentage, be careful not to include direct labor, overhead, or any costs other than direct materials.
This is the simple formula to calculate your manufacturing material margin:
Material Margin (MM) = Revenue (R) - Material Costs (C)
Material Margin % = (MM) / (R)
[Save this material margin formula as a handy infographic!]
If the material margin percentage is greater than 40%, you typically have sufficient margin to be profitable even in a complex costing structure and there is potential opportunity to drop more to the bottom line. For example, if revenue is $100 and material cost is $40, your material margin is $60, and your material margin percentage is 60%.
$60 (MM) = $100 (R) - 40 (C)
60% = $60 (MM) / $100 (R)
This means there is enough margin to be profitable and an opportunity to increase efficiency through product volume without a significant increase to non-material costs. We know the higher the material margin, the more profitable that job could be since overhead is a factor of complexity, not pricing.
If you suffer from low material margins, you have only two options to improve your bottom line: raise prices or lower material costs. If neither of those options are viable, your pricing will not allow you to be profitable or competitive in the market. Material margin analysis allows manufacturers to approach pricing from a different perspective, which eliminates the complexity when looking at the overall profitability potential.
The Impact of Inflation
Inflation has a profound impact on material margins across various industries that can cause a chain reaction down various distribution paths. Manufacturing companies, in particular, face significant challenges as they heavily rely on raw materials such as metals, plastics, chemicals, and energy to produce their goods.
To cope, companies often have to make tough choices–they can either absorb the increased costs and accept reduced profit margins, or choose to pass on the higher costs to their customers by increasing the prices of their finished products. However, such price hikes can make them less competitive in the market, but it is best to use the current or predicted cost of raw materials when making pricing decisions when inflation is high. Furthermore, inflation can also disrupt supply chains, causing additional delays, higher transportation costs, and other logistical challenges, further impacting material margins.
As a result, businesses must closely monitor inflation rates, adopt effective cost management strategies, explore alternative sourcing options, and consider price adjustments to navigate the impact on their material margins successfully.
Megan Johnson, CPA
Megan Johnson is a partner and client manager. She provides extensive business advisory expertise with a focus on strategic planning, tax planning, and management consulting. She specializes in financial and tax matters, business succession, and mergers and acquisitions with an industry focus in manufacturing and distribution. She has provided public accounting services at Redpath and Company since 1996.
SUBSCRIBE TO REDPATH INSIGHTS
You Can Search by Tag
- Accounting services
- BottomLine Newsletter
- Business Valuation
- Construction and Real Estate
- Corporate Development
- Employee Benefits
- Employee Engagement
- Estate, Gift, and Trust
- Financing M&A
- Mergers and Acquisitions
- Outsourced Accounting
- Paycheck Protection Program
- Performance Optimization
- Private Equity
- Sales Tax
- Sales Tax Rebate
- State and Local Tax
- Succession Planning
- Tax Credits
- Tax Planning Strategies
- Tax Reform
- Transaction Services
- Variable Interest Entity (VIE)
- Wealth Transfer