Financial records and economic principles should not be the exclusive domain of accountants and the IRS. Marketing executives will gain by using the more accurate ‘contribution margin’ approach to better allocate scarce marketing, sales and customer service dollars. Careful allocation produces greater overall long-term profitability.
Gross margin 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 enough guidance for strategic and tactical decision making.
The cost of goods sold, usually includes materials, direct labor, and some other costs directly related to producing finished products. The cost of goods is subtracted from total revenue to arrive at gross margin and margin percentage. This approach satisfies the IRS and shareholders, but fails to capture the real profitability of individual customers or product lines. That is where management needs more detail and greater accuracy.
Contribution margin is a term used in managerial economics. Contribution margin provides management with better information upon which to base decisions. Contribution margin seeks to more specifically separate costs that vary with the level of activity (or for individual customers or products) from other 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 level of activity whereas others relate to time. Determining the right category for a specific cost element still requires flexibility and good old common sense.
For example, a company’s income statement lumps all sales and marketing costs with other general administrative expenses, calling all of them fixed expenses. None of these expenses are, therefore, considered as part of total cost of goods sold. Based on normal accounting practice, the company shows a gross profit margin of 42 percent.
A closer look at the fixed expenses shows that sales commissions paid against the level of sales activity, along with freight expenses that vary with the level of sales, have been lumped together with other actual fixed expenses like rent, insurance, marketing and sales salaries, and other overhead expenses.
When management moves the additional costs that vary with sales level into cost of goods sold as “other variable costs,” the true margin percentage (now contribution margin) drops to a more realistic level of 33 percent. Fixed expenses decline by the same dollar amounts. Total costs remain the same but where they appear differs, providing a truer picture.
Why is this distinction important? Three factors affect break-even point. They are the:
- Level of sales revenue (activity level)
- Contribution margin percentage (after all costs that vary with activity)
- Level of fixed expenses (expenses that are essentially fixed for a time period)
When variable costs and fixed expenses are more accurately separated into their proper places, 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 contribution margin helps management is when decisions must be made about the allocation of marketing expenditures. Rather than lumping all marketing expenses together under the fixed expense category, a process now available from Religence can assign defined interactions (and their variable costs) to specific sales units, products, and even customers.
Example 1. It is a fact that retaining an existing profitable customer is much less expensive than the cost of acquiring a new customer to replace one who has stopped buying. Retaining high value customers often absorbs more time and money (management travel, meals, sponsorships, rebates) which should be assigned as part of that customer relationship to better understand an individual customer’s true profit contribution. The high value customer relationships may cost extra but, on balance, retaining them more than pays for those costs, resulting in greater overall profitability and longer customer retention. This is commonly accepted as so, but rarely is it actually known what it costs on an individual customer basis.
Example 2. The company acquired an account who had a long-time loyalty to a competitor. The effort started with multiple sales calls at a high cost/call. Overtime, the costs of mailings and attendance by the prospect’s buyer and several influencers at sponsored out-of -town seminars added to the variable costs of the solicitation. Months and months later, the company gained only a few sales at a deeply discounted price. The Chief Marketing Officer (CMO) questioned whether the sales were actually worth continuing the effort and expense.
How this could be different: The CMO puts available data to work to eliminate functional silos and implement practical marketing analytics to improve performance and profitability: Marketing management collaborates with financial management and a consulting firm like Religence to design and install a Customer Experience mapping and tracking process.
The company tracks individual cost to acquire and cost to retain (from specific relationship development interactions) to understand the overall variable Cost to Engage.
The basic formula: Sales revenue, minus all variable cost of goods, freight, and minus the variable Cost of Engage = Contribution Margin.
Correct contribution margins determine a more realistic cost connected with each prospect or customer during both acquisition and retention stages.
That intelligence combined with an understanding of how the relationship is developing allows the CMO to estimate the point at which a targeted prospect is likely to be uneconomical for them to pursue. A leading indicator for profit and satisfaction puts a number on each interaction for whether the relationship is moving backward or forward as a result. (We’ll get into more about our breakthrough metric Relationship Value in a future blog.)
The company avoids continuing the considerable waste of resources previously expended chasing low profit prospects.
The savings produced by avoiding low profit/high cost prospects during the acquisition stage allows re-allocation of more marketing resources to acquiring more high value customers and implementing a well-funded retention strategy.
Customer Experience Wisdom: Leaders use better information to optimize the use of scarce resources. Follow the money, if you can.
Questions: Do you know your Cost to Engage, your true Contribution Margin?
Can you predict which relationships are likely to be profitable?
Are you ready to move beyond anecdotal information, gut feeling? Then,