contribution margin

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.

one company, three sets of accounting records

In almost all countries publicly traded companies maintain three sets of accounting records.  They are:

–tax books in which the firm keeps track of the taxable income it generates, and the taxes due on that income, according to the rules of the appropriate tax authority.

Keeping the tax records may also involve a tax planning element.  A company may, for example, decide to recognize profits, to the extent it can, in a low-tax jurisdiction.  Or, as is often the case with US companies, it may decide not to repatriate profits earned abroad, at least partially because they would thereby become subject to a 35% tax.

Tax considerations can also have operational consequences.  For instance, a firm may choose to locate factories or sales offices in low tax jurisdictions over similar high tax alternatives mostly for tax reasons.

–financial reporting books, in which publicly traded firms keep track of profits, and report them to shareholders, according to Generally Accepted Accounting Principles (GAAP).

If the purpose of tax accounting is to yield the smallest amount of taxable income, and thereby the smallest amount of tax, the intent of financial reporting books can be seen as trying to present the same facts in the rosiest possible manner to shareholders.

The main difference between the two accounting systems comes in how long-lived assets are charged as costs against revenue.  Financial accounting rules allow such costs to be spread out evenly over long periods of time.  Tax accounting rules, which may be specifically designed to encourage investment, typically allow the firm to front-load a large chunk of the spending into one or two years.

The end result is that for most publicly traded companies, the net income reported to shareholders is far higher than that reported to the tax authorities.

management control books, kept according to cost accounting rules.  These are the records that a company’s top executives use to organize and direct the firm’s operations.  They set out company objectives and incentives, and are used to assess how each of its units are performing against corporate goals.  Not all parts of a firm are supposed to make profits.  Some may have the job of making, at the lowest possible cost, high quality components used elsewhere in the company.  A mature division may not have the job of growing itself anymore,  but of generating the largest possible amount of cash.

investment implications

Investors normally don’t get to see either a company’s tax books or its management control books.

Financial reporting books can sometimes give a picture that’s too rosy.  The two main culprits are deferred taxes and capitalized interest.  “Capitalized” interest is usually the interest on construction loans taken out for a project than’s underway but not yet finished.  Even though money is going out the door, under GAAP it’s not shown as a current expense.   I’ll explain deferred taxes next week.

In a very practical sense, you don’t need to understand either one too much (although it might be nice to).  Turn to the company’s cash flow statement in its latest SEC earnings filing.  Are there deferred tax or capitalized interest entries?  Do they add to cash flow or subtract from it?   …by how much?  If the answer is no, or that they add to cash flow, there’s nothing to worry about.  If they subtract–and a lot, on the other hand, there’s a potential problem.