This is a recounting of a conversation I had with a plant manager about the financial impact of missing shipment of his product for that month (which since it was December, was also be a miss for the fiscal year). The lesson is an old one: be sure to do a marginal (incremental) analysis when assessing the impact of a change in revenue, cost, or profit, and be aware of how you handle allocated fixed costs.

Me: So you may miss shipment for 5 units this month? How will that impact the company financially?

Plant Manager: Well, cost accounting shows that the profit for this product is $50,000, so this may be a $250,000 hit to the company.

Me: I’m afraid the impact will be larger than that. $50,000 is the average profit per unit (writing on my tablet):

Profit = Revenue – Variable Costs – Allocated Fixed Costs

But, what’s the financial impact if you don’t ship a unit?

∆Profit = ∆Revenue - ∆VC - ∆FC

∆FC = 0 (these are fixed costs, and don’t vary with volume), so

∆Profit = ∆Revenue - ∆VC

So the impact to profit of not shipping a product is its incremental revenue less its incremental variable cost. You said that revenue per unit is $1,300,000 and its variable cost is $1,070,000, so the impact to profit of missing shipment will be $230,000 per unit.

PM: That’s over $1 million in lost profit for 5 units!

Me: Sorry to be the bearer of bad news, but remember that ∆Revenue - ∆VC is sometimes called “profit contribution” which is a significantly larger number than the “profit” that cost accounting attributes to a product.

And the impact to cash flow (what really gets some companies in a bind) may be even greater. For example, what if much of the raw materials for this product are already purchased and sitting in inventory?

The impact to Cash Flow (∆CF) would be:

∆CF = ∆Revenue - ∆VC + (inventory already purchased for that item)

PM: I get the idea, but I’m not even going to calculate that number. But I do have a heightened sense of the financial impact of not being able to ship a customer order.