Know it all, know your Incremental Rate

Using the concept of the is a powerful tool for controllers and analysts. It provides them with insights of what the impact of a change in will have on operating . Quite handy but not always properly understood.

In essence your incremental rate tells you:
“If I increase my sales by \$1, how much will my operating profit increase”

As will understand, if you know this you can make better decisions when going out to get additional orders or project the impact of new business you are quoting for.

Unfortunately the concept is well known amongst financial people but it would be wise to educate your sales force on this concept.

Lets use a simplified example. Assume your financials look as follows:

Sales 1.000
700 -/-
300
Cost 175 -/-
Operating Profit 125

The incremental rate in this example is your contribution margin divided by your Sales (so 300/1000 = 30%). Meaning that every additional in sales you will earn 30 cents in aditional operating profit.

Lets test that so 100 more sales gives you the following picture

Sales 1.100
Variable Cost 770* -/-
Contribution Margin 330
Fixed Cost 175 -/-
Operating Profit 155 (before it was 125, so increase of 30)

We could have done this calculation much quicker by saying:

or
100 increase x 30% = 30 additional profit

A couple of important things you will need to know before you can actually calculate your impact on profit:

• Your variable costs — these move in the same relation as sales is they go up with the same amount (assuming they are proportionaly related to your sales volumes), if they are not completely variable (so not move proportionally with sales) you need to classify which part of the variable costs are fixed.
• Your – these do NOT move in relation to sales and stay fixed for the year.
• In the long run every thing is variable so limit your horizon when calculating your incremental rate to a one year period or less
• A budget or plan that you can base your calculations on (typically done once a year)
• Quotating new orders at variable costs is fine if you have already earned your fixed costs back but remember that in next year’s you up your selling to the market value — this example should only be used for additional (over and above) orders
• If you have spare capacity this calculation does not apply as you may not yet have not earned your fixed costs back yet with your normal production (so quoting something as low as your variable cost may seem the right thing to do, but in fact its not)
• You can calculate incremental rate not only on a unit level, but also on product groups, organizations and business units

If you are in Sales and you are not sure about how to calculate all this information, I recommend you schedule a meeting with your controller to understand your incremental rate for your business.

We will continue with this subject later on when making investment decisions or deciding what your lowest price could be when making a sale.

Stay tuned for more! Post a message or send us any questions: finance@kingcashcow.com