Yielding higher contribution...

How do costs behave? Could a deeper understanding of cost behaviour help you more deeply understand your products and services? Would you be able to optimize procurement / investment options if you more deeply understood which products and services drive which costs? What about break-even? Do you know at what operating rate you start generating profits? Our sentiments are that the time has arrived where organizations need to more deeply understand their cost structures – and not solely for the perspective of minimizing them. Without costs there would be no investment. Without costs there would be no growth, no innovation, no prospect for a better future. What is needed is a deeper understanding of costs, a better utilization of costs, understanding the cost drivers and what costs should be incurred to drive top-line revenue. We support a contribution margin accounting philosophy to gain that deeper understanding; identifying the various cost drivers, determining the split between fixed and variable and building the contribution margin statement for various characteristics (entities, products, customers) within the organization. Our typical contribution margin statement would look something like this:

It is every organizations objective to maximize it’s contribution margin. The contribution margin contributes to covering fixed costs within the organization. Break- even is reached where contribution margin equals fixed costs. Any contribution after break-even immediately results in higher profit to the organization. Leading organizations calculate contribution margin at the customer and product level. Efforts are focused on those products and customers with the highest contribution margin as they are the highest contributors to overall organizational profitability.

The Theory of Sensitivity of Cost to Business Activity: Over the longer term (and with the exception of long term contracts/commitments) all costs are variable because fixed cost can be eliminated. In the short term most costs are fixed. In practice and for the budget process a view is taken at a specific time of the year. Variable cost are planned for a specific business activity. These costs are expected to vary depending on activity volume as well as on product / service mix which makes them controllable. Fixed cost are budgeted and they are not sensitive to the business activity.

Managing your organization based on contribution margin philosophy yields the following advantages:

• Being able to determine the break-even point from an actual quantity point of view when reviewing various budgets / simulations and forecasts
• Better understanding which customers & products contribute optimally to overall organizational profitability
• Optimize CM in case of profit limiting factors such as capacity constraints (CM per capacity unit). An example might be that you have limited capacity on a specific work center. You would then focus and give higher priority to those products yielding a higher contribution.
• Manage the sales force based on CM (incentives) and measue CM-% on sales value, valued added or a specific resource (e.g. a constraint).
• Choice of whether to treat fixed costs as periodic charge or amount to be included as part of stock valuation
• Improved pricing capabilities by having the ability to target a specific contribution margin in the quotation process