several sets of corporate books
As I’ve written in a previous post, publicly listed companies have three sets of books:
–financial reporting books, which tend to portray a rosy picture to shareholders,
–tax books, that tend to show a relatively grim picture of profitability to the taxman, and
–management control or cost accounting books, by which the company is actually run.
Contribution margin is an important concept for this last set of books, the management control ones.
what contribution margin is
The first thing to be clear on is that people call contribution margin is not always a margin, that is, a percentage. More often a contribution margin is expressed in absolute dollar amounts. Don’t ask me why.
But what is it?
It’s the amount by which the revenue from selling an item exceeds the direct cost of production and thus “contributes” to defraying corporate overhead. It can be positive or negative. Negative is very bad. The concept can be used at every level of corporate activity, from an individual widget made in a plant, to the total output of the plant, to a mammoth division inside a multi-line company. It’s not a measure of profit; it’s the basic measure of cash generation. The question it answers at any level is, “Does this operation generate a positive return, before loading in charges for corporate ‘extras’ –like the CEO’s salary, R&D, image advertising, the corporate jet fleet…”
why it’s an important concept
It makes you focus on incremental cost, not total cost. For example,
1. It tells you the point at which a company begins to consider shutting an operation down–namely, when the contribution margin turns negative.
I was reading a report the other day about the gold industry that maintained the gold price was in the process of bottoming because the “all in” or “fully loaded” price of producing an ounce of gold for the global gold mining industry is about $1,100 an ounce. How embarrassing for the author! That’s not right. Yes, at under $1,100 an ounce, a generic mine may be showing a financial reporting loss. But it’s still generating cash–in fact, the lowest-cost mines are probably generating $500 in cash an ounce. Only the highest cost operators will think about ceasing mining.
What will firms do instead? They’ll cut corporate overhead, for one thing. If they decide that the value of their plant and equipment is permanently impaired, they’ll write off part of the carrying value of this investment on their balance sheets. That will lower ongoing depreciation charges, by. let’s say, $100 an ounce (a number I just made up). That will magically transform the financial accounts from red ink to black. But this change won’t alter the cash flow generation from operations.
2. It highlights an operation’s value. Suppose an operation has a contribution margin of $1 million a year, but all that–and more–is eaten up by corporate charges. It can be sold to, or merged with, another operation in a similar situation. The ” synergy” of eliminating duplicative administrative functions may turn two apparent losers into a combined money-maker. In any event, the $1 million yearly contribution to overhead has a significant value.
3. It invites you to look at breakeven points–and the often explosively strong effect that finally covering overhead costs can have on profits. Hotels are the example I often thing of. As a general rule of thumb, a hotel is breakeven on a cash flow basis at 50% occupancy. It breaks even on a financial reporting basis at 60% occupancy. Above that, profit flows like water into the accounts. IN this case, a relatively modest shift in occupancy can change the profit picture dramatically–and that’s without regarding the possibility of room-rate increases.