I first wrote about break even analysis and the cost volume profit relationship in 2008 and I've written several time about it recently and I've realised that I've never taken a deep look at the contribution margin.
What Is The Contribution Margin?
Contribution is the difference between the sales price received from the customer and the variable costs of buying, making and delivering the product or service.
These costs are also sometimes called marginal costs or direct variable costs.
You may already know this as gross margin or gross profit but too often, these measures are shown in the accounts after the deduction of some fixed costs which will cause confusion and potentially lead to wrong decisions.
A Numbers Example
Let's look at an example.
You sell 500 units for £30 each, making a total sales revenue of £15,000 in a month.
You buy these units for £12 each, giving a total cost of sales of £6,000.
You also pay courier charges to get these goods to the customers of £1,200.
The goods are despatched from your warehouse by your two staff who earn £1,500 each and the rent on the warehouse is £1,000 for the month.
The variable costs mentioned above are the cost of buying the goods sold of £6,000 and the courier costs of £1,200.
The warehouse wages and rent are fixed costs because they don't vary directly with your sales volume. If you'd sold 300 units or 700, these costs would have been the same.
The contribution margin is therefore:
Sales Revenue £15,000
Less Goods Sold £6,000
Less Courier Costs £1,200
Contribution Margin = £7,800
This margin can be expressed as a % of sales revenue = 52%
Or as a contribution per unit = £7,800/500 units = £15.60
With fixed costs of:
Warehouse wages = £3,000
Rent = £1,000
Total fixed costs = £4,000
The profit for the month is (7,800 - 4,000) = £3,800.
The break event point would have been:
In units (4000/15.60) = 256.4 units
In sales value (4000/52%) = £7,692
Check on sales value - 256.4 units at £30 each = £7,692
If you're not familiar with break event points, please read
Contribution Margin Is The Real Income Of A Business
Business owners can get into a mess if they focus too much attention on the value of sales revenue and too little on the value of the contribution margin.
To prove the point, we can look at the sales value, contribution margin from both directions:
Sales Revenue = 10,000, Contribution Margin % = 5%, Contribution = 500
Sales Revenue = 10,000, Contribution Margin % = 10%, Contribution = 1,000
Sales Revenue = 10,000, Contribution Margin % = 20%, Contribution = 2,000
Sales Revenue = 10,000, Contribution Margin % = 30%, Contribution = 3,000
Sales Revenue = 10,000, Contribution Margin % = 40%, Contribution = 4,000
Sales Revenue = 10,000, Contribution Margin % = 50%, Contribution = 5,000
Sales Revenue = 10,000, Contribution Margin % = 60%, Contribution = 6,000
Sales Revenue = 10,000, Contribution Margin % = 70%, Contribution = 7,000
That looks pretty straightforward, doesn't it?
There's a linear relationship between sales value and contribution value.
But what if we look at it from the other direction.
Let's assume that we have fixed costs of 5,000 to meet each month and look at the break even sales value at different contribution rates.
Remember, the break even point is fixed costs divided by the contribution margin.
Fixed Costs = £5,000, Contribution Margin % = 70%, Break Even Sales = £7,143
Fixed Costs = £5,000, Contribution Margin % = 60%, Break Even Sales = £8,333
Fixed Costs = £5,000, Contribution Margin % = 50%, Break Even Sales = £10,000
Fixed Costs = £5,000, Contribution Margin % = 40%, Break Even Sales = £12,500
Fixed Costs = £5,000, Contribution Margin % = 30%, Break Even Sales = £16,667
Fixed Costs = £5,000, Contribution Margin % = 20%, Break Even Sales = £25,000
Fixed Costs = £5,000, Contribution Margin % = 10%, Break Even Sales = £50,000
Fixed Costs = £5,000, Contribution Margin % = 5%, Break Even Sales = £100,000
The simple business with fixed costs of only £5,000 per month needs just £7,143 of sales revenue if it can achieve a contribution margin % of sales of 70%.
But it needs £100,000 of sales revenue if the contribution is only 5% of sales value.
The nice linear relationship of the contribution margin seen in the first set of numbers has turned exponential when we want to break even.
It's this that confuses business owners and managers when they think about discounting prices to increase sales or talk themselves out making a much needed price increase.
Can You See Why Contribution Margin Is Your Real Income?
If your business has margins that vary between products and/or between customers, can you see why I'd like you to reduce your focus on sales value and increase the attention you make to the margin you make on sales?
It's very easy to get fooled by a high sales value in a month and to think that your business is making lots of money.
It will be if you've managed to hold your contribution margins but if you've been discounting, you could be in for a nasty shock when the accountant does your monthly accounts.