Applying the Contribution Margin Principle

The key to profits is contribution margin—how much margin each product line or business unit contributes to a customer's total profits. Affecting a customer's contribution margins is a key objective of Consultative Selling. There are two ways to do this. You can help increase sales volume at the current contribution margin. Or you can help increase contribution margin at the current volume of sales.

Figure 8-3 shows how contribution margin works. It is calculated by subtracting variable costs from sales revenues. In the example, a customer's total contribution margin is 9.5 percent. That means that each single dollar of sales is currently contributing a margin of 9.5 cents to cover the customer's fixed operating overhead of $221,000. It takes a lot of $1 sales to contribute enough 9.5 cents' worth of margins to cover $221,000 of overhead. Even when sales do that, the customer merely breaks even. That is where you come in. If you can increase sales or decrease the variable costs that subtract from sales revenues, you can improve customer profits.

	Total	Product Lines
		A	B	C
Sales	$2,600.0 100.0%	$1,742.0 67.0%	$650.0 25.0%	$208.0 8.0%
Cost of sales	$2,106.0 81.0%	$1,440.0 82.7%	$520.0 80.0%	$146.0 70.0%
Gross profit (1-2)	$494.0 19.0%	$302.0 17.3%	$130.0 20.0%	$29.8 29.8%
Wages	$221.0 8.5%	$134.0 7.7%	$65.0 10.0%	$22.0 10.6%
Other	$26.0 1.0%	$10.0 0.6%	$13.0 2.0%	$3.0 1.4%
Total (4 + 5)	$247.0 9.5%	$144.0 8.3%	$78.0 12.0%	$25.0 12.0%
Contribution margin (3-6)	$247.0 9.5%	$158.0 9.0%	$52.0 8.0%	$37.0 17.8

Figure 8-3: Analysis of profit contribution by product line ($000).

The consultant's choices are shown in Figure 8-3. If you want to work on product line A, you can improve profits best by improving sales. While it has only a 17.3 percent gross profit, it also has a 9.0 percent contribution. Any increase in sales volume produces new profits. On the other hand, if you work on product line B, you have to reduce its variable costs. Its 20 percent gross profit exceeds that of A. But it is making only an 8.0 percent contribution after variable expenses. If you can reduce its expenses, you can improve its contribution even without increasing sales volume.