Contribution margin analysis: An overlooked tool for profitable decision-making

Over my 31 years working with CEOs, virtually all of my clients have expressed a desire to make more money. For those with multiple products, the math has generally seemed quite simple: just sell more of every product. One client, for instance, had three products. Product A sold for $10,000, Product B for $20,000, and Product C for $40,000. The marching orders to the sales force were to sell more of all three.

However, a deeper level of analysis led to a different conclusion. When we considered the gross profit and gross margin on each product, we recognized that not all revenue dollars are created equal.

When the cost of goods sold (CGS) was subtracted from each of the three products, these gross profits were revealed:

• Product A: $5,000 (50 percent gross margin: $10,000 revenue less $5,000 CGS).

• Product B: $8,000 (40 percent gross margin: $20,000 revenue less $12,000 CGS).

• Product C: $10,000 (25 percent gross margin: $40,000 revenue less $30,000 CGS).

Since my client was more interested in real dollars than percentages, he was now inclined to shift his selling focus to Product C. However, it was at this point that we began to consider the concept of “contribution margin analysis.”

What is contribution margin? It is gross profit less any variable costs beyond those embodied in CGS (CGS typically includes labor and materials to create finished goods). In this case, the additional variable costs were sales commissions of 20 percent on revenue. With this in mind, contribution margins for the three products were as follows:

• Product A: $3,000 (30 percent contribution margin: $5,000 less $2,000 in commissions).

• Product B: $4,000 (20 percent contribution margin: $8,000 less $4,000 in commissions).

Product C: $2,000 (5 percent contribution margin: $10,000 less $8,000 in commissions).

When this analysis was reviewed, the CEO of my client company was shocked. He looked me in the eye and exclaimed, “Wait a minute! Our fixed overhead expenses are running at about $1 million each year. This data says that if our heaviest emphasis is on selling Product C, we will need to sell $20 million to just break even!”

He was right — and applying the same logic, a focus on Product A would require only $3.3 million in sales to break even. What’s more, both Product A and B were much easier to produce and sell than Product C.

So what were my client’s product strategy options? They boiled down to:

• Substantially raise the price of Product C, which unfortunately would make it uncompetitive in the market.

• Discover ways to substantially reduce Product C’s CGS.

• Reduce the commission rate for sales of the product.

• Some combination of the preceding options.

OR —

• Phase out Product C altogether.

Initially, the last option was the least appealing to the CEO. It would mean that topline revenue would be substantially reduced and the perception both within the business and the marketplace might be that the company was in trouble. However, as the executive team and sales personnel recognized that phasing out Product C would allow a more intensive focus on the remaining products, they made that decision. A careful, well-executed and well-communicated phase-out allowed them to become a leaner, more profitable and agile company.

Too often, small-business leaders don’t understand the importance of contribution margin. It requires careful recasting of company income statements, especially when deciding on what constitutes variable costs beyond the direct costs of CGS. In this analysis, it is critical that any expense shifted to this variable category truly does vary directly with the sales of the respective products.

In recasting, please also be aware that the contribution margin version must be in addition to your customary P&L, not a replacement for it. Contribution margin, while a valuable tool for executive decision-making, is not considered to be in line with “generally accepted accounting practices” for financial reporting.

If you are a multi-product company, I strongly recommend that you add contribution margin analysis to your arsenal of financial tools.

Richard Tyson is the founder, principal owner and president of CEObuilder, which provides forums for consulting and coaching to executives in small businesses.