This note goes through the concept of contribution margin on a per unit basis, as a simple way to think about a Company's profitability. This will then be applied to specific business profiles in future notes.
Setting the Scene
Let’s imagine a hypothetical scenario with two companies:
- From a revenue perspective, both companies have exactly the same revenues and growth profile.
- From a contribution margin and a profit/(loss) perspective, Company Two’s financials are slightly worse.
Contribution Margin per “Unit of Cost”
The first step is to split CM costs in two buckets: (i) 100% variable regardless of revenue level and (ii) fixed costs up until a certain revenue level.
The second step is to then analyse each bucket independently:
- Fixed CM costs: the company pays for this cost within a certain capacity figure linked to revenues. For example, it could be the salary of a sales person. The agent can bring in up to a certain revenue level; every month the revenue generated changes but the salary paid remains the same. This is a simplification, as in practice there are several “Fixed CM costs”, each incurred for up to a certain revenue level.
- Variable CM costs: this could be for example an agreed % of revenues paid out as bonus to sales agents. Given that it is variable, it protects margins and therefore profitability whenever there is a decrease in revenues. However, it cannot be so high that nothing is left for the Company. Coming back to the original question, below is an overview of the CM costs for Company 1 and Company 2. For either company a sales person can get each month one to six new clients. The typical performance for 80% of the people is 2-3 clients per month.
- Fixed CM costs: given the higher revenue per client, Company One has an advantage over Company Two (25% vs 45% of revenues).
- Variable CM costs: it is very clear that Company One’s costs are simply too high at 80% of revenues (vs 40% for Company Two).
Even with a more favourable position from a fixed costs perspective,
it will be impossible to become profitable, given that for each sales person
(or unit cost), Company One has a loss of (£600-1,400). If they add more
sales people, revenues will grow but the loss will only become worse over time.
It is very interesting to notice that many times important questions about a business’ profitability can be determined using a few key numbers. It is not necessary to use a complex spreadsheet to draw conclusions.
Digging out of a Hole
Coming back to the previous example, over a 24 months period, both companies grew their revenues at exactly the same pace (from £79k to £2.7m) but the CM profile was completely different. By month 12, one would think that Company Two was in trouble but in fact a few quarters later, it managed to grow CM to cover Overheads.
Based on the previous section, this is not a surprise, as Company One made a loss of (£600-1,400) per sales person per month, while Company Two was digging out of a hole (see figure below) as it grew its revenues and CM, as the number of sales people increased.
Contribution margin on a per unit basis is a very powerful way to think about a Company's profitability. It simplifies everything and makes it easier to have key insights about a business. More to come on this in future notes.