When you want to check the financial performance of an organisation, the first and most obvious indicator is profitability. Even in the ‘not for profit’ sector, profit is the key indicator of financial performance – has the organisation operated within its income for this and the most recent years? Has it generated a surplus to reinvest in social impact and organisational sustainability and growth?
It’s easy to lean on profitability as the key indicator of financial success, and sometimes as a proxy for good organisational governance and management. Whilst profitability is the key driver of organisation sustainability, viewed in isolation, it can be a bit of a blunt instrument. The key risk is that overall organisational profitability can hide a lot of issues. Whilst the results for the business as a whole might look great – and they may genuinely be reflective of business performance as a whole – you could have some significant losses hiding behind some hero income streams.
It’s always been important for us to understand the different factors that make up our organisational performance, but never more so than now. As we try to navigate the volatile and uncertain impacts of COVID 19, it’s likely that many organisations are going to have to make some tricky decisions about future services and activities, and that requires good visibility on which parts of your business are driving – or undermining – your overall result.
This is where a contribution margin analysis of your service or products comes in.
Defining contribution margin
As with many accounting and finance terms, the term ‘contribution margin’ can be interpreted and used in different ways.
Investopedia defines contribution margin as “the incremental money generated for each product/unit sold after deducting the variable portion of the firm’s costs. The contribution margin is computed as the selling price per unit, minus the variable cost per unit. A variable cost is a corporate expense that changes in proportion to production output”
A variable cost can also be thought of as a direct cost associated with providing the service or product. For example, a one hour physiotherapy session will require the direct cost of one hour of a physiotherapist’s wage.
So, the contribution margin shows how much financial contribution a product or service is making to the organisation, after the direct costs of providing that service have been taken into account. A contribution analysis will demonstrate the financial impact to your organisation of your different services and products. When you combine this with an understanding or evaluation of the social impact of your products and services, it may highlight how one product with a high contribution margin, funds another product that has a low contribution margin, but high social impact. This will inform decisions around which products or services to continue, discontinue or actively expand. Additionally, during a period of decline or growth, a contribution analysis will highlight which products or services have been most impacted by business change.
Calculating Contribution Margin
To calculate the contribution margin of a service or product you will need two items
- Revenue of the service or product
- Direct costs associated with providing the service or product
Following on from the previous example, if the physiotherapy session is charged at $100 for the hour and the physiotherapists costs the organisation $60 for an hour of service, then the contribution margin would be $40 per one-hour physiotherapy session.
Differentiating between direct and in-direct costs
One of the most challenging parts of calculating contribution margins is differentiating between direct and indirect costs. Some costs will of course be easily identifiable as one or the other, however many costs will fall into the grey area of possibly being both direct and indirect costs. For example, if the organisation’s insurance covers (amongst other things) the work conducted by the physiotherapist, is this a direct or indirect cost?
Assigning costs as either direct or indirect can be a highly complicated and time-consuming exercise depending on the service or product.
One suggestion is to calculate the contribution margin using the costs that are very easily identifiable as direct costs and undeniably associated with delivering the service or product. The hourly wage of the physiotherapist to deliver the one-hour physiotherapy session would be an example of an easily identifiable direct cost.
Although this methodology may miss some direct costs and potentially over inflate the contribution margin of a service or product, it is a great starting point. It is worth mentioning that with this methodology, it is unlikely that the contribution margin will be understated as only easily identifiable direct costs are used in the calculation. So, when reviewing a product or service with a low contribution margin, keep in mind that – as only the easily identifiable costs were used in the calculation – you can assume that the contribution margin is overstated and the likelihood is= that the product or service is not financially sustainable on a stand-alone basis.
The importance of the contribution margin
The contribution margin “contributes” towards your fixed or indirect costs (such as head office rent, insurances, utilities and audits) and to your organisation’s net profit.
Understanding the contribution margin of different services and products is key to determining their viability from a purely financial perspective. Balancing contribution margin against the social impact of a product, allows for a meaningful discussion about continuing or withdrawing a particular activity, or investing for growth. Organisations that are financially sustainable overall may choose to continue a service with a low contribution, due to the social impact that the service has.