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Fancy Name - Simple Idea

01 Sep 2010

Someone once said ‘knowledge is power’. In a business context, this translates to “information is power”. Information enhances organisation value through superior decision-making. Your accounting system may also be a source of valuable information. The subject of this article is Contribution Margin (CM).

Simply, CM is understanding that some costs are: (1) fixed costs (FC) – they do not vary with the volume of goods or services produced. There is no direct link between the cost and production of a particular product or service (an example is rent); and (2) variable costs (VC) – they vary with the volume of goods and services produced. There is a direct link between a particular cost and the production of a particular product or service (an example is production materials).

The transaction data captured in the accounting system may be converted with analysis into information. Knowing what variable costs relate to particular products or services and what your fixed costs are, is valuable information and may be used to make decisions about how to price new products or services and when to stop producing a particular product or service. Let me give an example:

                         Wigets                 Dudlets

Sales                   400                      300

VC                     100                      200

CM                     300                     100

FC allocated        150                     150

Profit/(Loss)       $150                   $(50)

A company has two products: Wigets and Dudlets. Let’s say just one of each is produced and sold. The following information is extracted from the accounting system: Fixed costs are allocated evenly between the two products because one of each was produced. Total company profit is $100.

You may be tempted to stop producing the Dudlets because they are making a loss. But if you stop producing the Dudlets, you are worse off because the Dudlets have a positive contribution margin ($100) and are contributing to paying the fixed costs.

                              Wigets

Sales                           400

VC                             100

CM                            300

FC allocated                330

Profit/(Loss)                   0

The other important piece of information is that the price of the Dudlets could be reduced to $201 and the company would still be better off producing than not producing them. This is important if facing tough pricing competition, or when launching a new product or service, or when you want to offer an ancillary product or service.

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