Many years ago, I went to work for a rapidly growing, successful company. One of the first items presented to me was the company’s effort to move production of the top two selling items in the firm to a production facility in Mexico. Management was really excited about this opportunity. I remember distinctly being told that the company would save 15% on these products once transfer of production took place.
Finally, the day came and production of these units was transferred to the supplier in Mexico. Management was very anxious to see the effect on the financial statements. Results the first month were poor. Profits dropped but a quick analysis seemed to indicate that this was probably a result of initial costs associated with transferring production to Mexico. However, when our profits dropped in each of the following three months, we became concerned. Management had signed a long term contract and we were stuck.
So what was wrong? Management paid attention to total costs. They had not understood how their costs were configured. Put another way, they didn’t understand the difference between fixed costs and variable costs. Their original variable costs were less than the new variable costs from the new supplier in Mexico. All the fixed costs still remained with the company, only now; we were not able to offset the fixed costs with the same contribution margin, previously enjoyed.
So what is contribution margin? Contribution margin is the difference between your selling price and your variable costs. In the simplest form, imagine a retailer hat buys merchandize for $5 and sells that item for $11. The contribution margin is $6 ($11-$5). The calculation for a manufacturing company can be more complicated but the general premise remains. The key is to know your variable costs.
Unfortunately, this isn’t my only example. In another instance, the firm sold most of their product through large retail outlets. However, about 10% of sales were sold through a professional installation network. When the gross margin for this product was examined by non-financial personnel, they saw a gross margin of only 10%. They demanded action! It was obvious we needed to “axe” the drain on our resources and profitability. There were also outside pressures on the firm seeking the elimination of this distribution network.
Eventually, the company made the decision to eliminate this professional installation division. The results were disastrous. Almost immediately, all our dealers moved to our biggest competitor, significantly strengthening our competition. Worse still our profits began to suffer considerably. Why?
The answer was obvious once we began to dig deeper into the numbers. We had focused on the gross margin of 10% and ignored our contribution margin. In this case, our contribution margin was about 70%. This meant that our variable costs were only 30% of sales. So this division with only about $2 MM in sales was covering $1.4 MM of fixed costs for the company.
$2,000,000 – (.3 X 2,000,000) = $1,400,000
We had failed to look at the costs that mattered. We didn’t understand how much this division affected our profitability by covering our fixed cost. In the end, the company was sold to its biggest competitor. The competitor consolidated all activities to the national headquarters and the company ceased to exist. As a business person, know your cost so you can calculate your contribution margin.