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- Richard P. Morgan CMC, FIMC
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Contribution margin for marketers
Financial records and economic principles should not be considered the exclusive domain of accountants and the IRS. Marketing executives will profit from developing and using the more accurate contribution margin approach to better allocate scarce marketing, sales and customer service dollars and produce greater overall long-term profitability.
Gross profit and contribution margin are not interchangeable terms. Everyday income statements are designed to meet generally accepted accounting practices (GAAP) and to satisfy the Internal Revenue Service. They do not offer management much guidance for strategic decision making.
The cost of goods sold, including materials, direct labor, and some other costs directly related to producing finished products, is subtracted from total revenue to arrive at gross profit and gross profit margin. This approach satisfies the IRS and shareholders, but fails to capture the real profitability of individual customers or product lines. That is where more details and greater accuracy is necessary.
Contribution margin is a term used as part of managerial economics that attempts to provide management with better information upon which to base decisions. Contribution margin seeks to more specifically separate costs that vary with the level of sales activity or for individual customers or products from expenses that are essentially fixed during the time period involved. Ultimately, all costs and expenses may vary based on external and internal factors but during a time period under analysis, some expenses relate to time whereas others relate to the level of activity. Determining the right category for a specific cost element still requires the exercise of flexibility and good old common sense.
For example, a company’s income statement lumps all sales, indirect, and administrative expenses together as fixed expenses. None of these expenses are considered as part of total cost of goods sold and the company shows a gross profit margin of say 42 percent.
A closer look at the fixed expenses shows that sales commissions paid against the level of sales, along with freight expenses that vary with the level of sales, have been lumped together with other legitimate fixed expenses like rent, insurance, marketing, and other overhead expenses.
When the additional costs that vary with the level of sales are included in cost of goods and the other variable costs, the true margin percentage (now contribution margin) drops to a more realistic level of say 33 percent and fixed expenses drop by the same dollar amounts.
Why is this distinction important? Three factors affect break-even point.
1. the level of sales revenue or activity level
2. the contribution margin percentage (after all costs that vary with sales activity)
3. the level of fixed expenses (other expenses that are essentially fixed for a time period)
When variable costs and fixed expenses are more accurately separated into their proper categories, management is in a much better position to calculate and predict break-even points and to make decisions regarding allocation of its scarce resources.
One time when true contribution margin helps management is when decisions must be made about allocations of marketing expenditures. Rather than lumping all indirect marketing expenses together under the fixed expense category, information systems and a process now available can assign variable costs to specific customers.
Example 1. Retaining high value customers often absorbs more time and money (management travel, meals, sponsorships, rebates) which can be placed as part of that customer relationship to better understand an individual customer’s true profit contribution. The high value customer relationships cost more but, on balance, retaining them more than paid for those costs, resulting in greater overall profitability and longer customer retention.
Example 2. Acquiring a certain account, with a long-time loyalty to a competitor, started with multiple sales calls at a high cost/call. Soon, the costs of mailings and attendance by the prospect’s buyers and influencers at sponsored out-of -town seminars added to the variable costs of solicitation. At some future point, a few sales were made at a deeply discounted price. The Chief Marketing Executive (CME) wondered if the sales were actually worth all the expense.
“Effective marketing doesn’t take millions. It takes imagination, enthusiasm, and the willingness to experiment and change.”
Richard P. Morgan CMC, FIMC
$ Million Marketing Tips
Tip: Use extra time at the end of the year to review your activities. Identify what worked and what you may want to change going forward. Set goals and form your overall strategy.
Tip: You need to understand what position you now have in customer’s minds. That is your reality. You start influencing (marketing) efforts from where you are and work toward the position you want in the future.
The Market-focused Guide to Company Analysis by Richard P. Morgan CMC, FIMC
Marketing Facets is a practical resource for those involved in determining the current health of a company and gauging its future prospects. Designed to be a supplement to other due diligence or business evaluation work, the 103-page guidebook takes a holistic approach. The guidebook assembles facts about twenty-five marketing functions along with management assumptions in key areas to help analysts form and support conclusions about the enterprise.
Marketing Facets is a valuable resource for private equity fund managers, individual investors, investment banks, and valuation specialists. C-level executives will find Marketing Facets a helpful guide for internal analysis, as part of normal business planning, or in advance of efforts to refinance or divest.
Marketing Facets is available in electronic form via the Internet, on CD/ROM, or in print with a ring binder.
> Electronic in MS Word or Adobe .pdf format via the Internet @ $80.00
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Copyright 2014, Morgan Marketing Solutions, Inc.
Richard P. Morgan CMC, FIMC
Morgan Marketing Solutions, Inc.
Two Galleria Tower, Suite 1000
13455 Noel Rd, Dallas, TX 75240-6620
Author, Marketing Facets – The Market-focused Guide to Company Analysis
CMC (Certified Management Consultant) is a mark awarded by the Institute of Management Consultants USA, and represents evidence of the highest standards of consulting and adherence to the ethical canons of the profession. Less than 1% of all consultants have achieved this level of performance and dedication. The CMC process is now recognized as an ISO17024 process. For more information go to www.imcusa.org.