Profit Mastery: The Contribution Margin Is A Very Important Number
Gross sales? Target revenue? Break even? No, this figure is more important than all those.
These days, as we're all looking at ways to cut costs, figuring out where and how to cut is extremely important. Using break-even analysis allows you to go in with a scalpel instead of a hatchet.
If we said there was one number that you (and everyone else in your company) should absolutely know off the top of your head these days to do this analysis, what number would you say? Targeted annual revenue, perhaps? Break-even sales level per month? Total costs?
While all of these are good ones to know, the key number is the amount that's left over from every dollar of sales, after paying your variable costs, to then pay for your fixed costs, and then once those are paid for, to put towards your net profits.
While financial experts call this the contribution margin (CM), the highly technical term we have for it around our company is, "what's left over."
What question can you answer with this number?
- If you have to cut costs, as most of us are these days, how will it affect the volume of sales you need to break-even?
- If you want to invest in a new product line or piece of equipment, or hire a new salesperson, what exactly do you need to generate in sales in order to pay for the line, equipment, or person?
- And at the most basic level, for every dollar increase in fixed costs, how much in sales do you need to make to cover it?
To arrive at this number, total your variable costs, i.e. the costs that either rise or fall with sales (i.e. they're proportional to sales). For most stores, the vast majority of variable costs will be found in your cost of goods. Other examples of variable costs would be direct labor, "percentage rent," and royalties. Total these variable costs and then divide them by your total sales to get a percentage. Let's say this percentage for your company is 48%.
Now take 100% - 48% = 52% to arrive at the contribution margin, aka "what's left over." Now take that number, 0.52 and divide it into $1.00. $1/.52=$1.92.What this equation says in words is that for every dollar you increase fixed costs, you need $1.92 in sales to cover the increase.
How can you use this? For example, if it's going to cost you a total of $100,000 to get into a new product line and promote it, you'll need to make at least $192,000 ($100,000 x $1.92) in sales to cover it.
Or conversely, if you are looking at cutting a cost, such as reducing salaries by $10,000 a year, you know your sales can drop by $19,200 and you can still make the same profit as you did before.
If your employees knew this number, they would know that if they waste materials worth $1,000, they would need to make it up by selling an additional $1,920. Most of us think if we mess up something that's worth a dollar, all we need to do is sell another $1.00 to make up for it. Fatal flaw. We forget that for each dollar of sales that comes in, we first need to pay for our variable costs before we even begin to start paying for our fixed costs. And only after we finish paying for those fixed costs can we take home any profit.
Editor's note: This is the first in a series of articles focusing on specific financial tools and techniques franchisees/employees can use to measure, manage, and improve performance.
Steve LeFever and Dave Ashcraft are, respectively, Chairman and Vice President of Business Resource Services/Seattle. For over 10 years, they have provided financial training, performance benchmarking, and accountability/bankability modeling for franchisors and franchisees. Contact them at: 800.488.3520 x14 - or email@example.com. Please email them with any suggestions for topics you'd like to see covered in future columns.
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