One of the most important business concepts derived from incremental thinking and economics is the metric of “contribution margin”. When offered a deal by a customer to buy at a low price, we should say “yes” as long as the incremental costs are less than that price. Or, said another way, when incremental (additional) revenue exceeds the incremental (additional) costs it makes sense to proceed. Or, another way to say it is as long as our price is high enough to cover variable costs and any fixed costs (which we’d have to pay anyway), it makes sense that profit will rise if we go and supply. Another formulation of the decision rule is that  (P – AVC) > 0 : price – variable costs is the definition of contribution margin. As long as contribution margin is positive, profit rises if we supply. This metric, and this way of thinking, stresses the point that fixed (sunk, overhead) costs are irrelevant to supply decisions in the near term (as long as we have enough capacity in plant and equipment and long term faculty commitments to do the job). And, of course, we must also assume that our regular customers won’t find out about the deal!

The calculated amount of incremental profit is called, in business jargon, the contribution margin. How much is the deal contributing to profit? Here, we take the incremental revenue and subtract the incremental costs.

Some Quick definitions:

Total costs = all expenses for some period of time=  Variable costs + fixed costs

Average costs = unit costs = total costs / output level

variable costs = the costs that vary with the amount of output we produce — if we             produce additional units of output then our variable costs go up, if we choose to produce less then our VC go down

marginal (incremental cost) = the additional variable costs we incur when we                     produce an addition unit of output

sunk cost = fixed costs = obligated costs we must pay regardless of our level of                   output (these are the alternative to variable costs, which go up and down with             output level. We are obligated to pay these costs (the CEO salary, the rent,                       building maintenance) whether we produce any output or not. It is a                               contractual obligation of sorts.

Total Revenue = average price  x  total units sold

Incremental revenue = the amount of additional revenue we get (or give up)                       when we sell an additional unit of output. This may or may not be = the                         average price we charge (if we give a discount, for example, the additional                   revenue we get would be lower than price).

Contribution margin = incremental revenue – incremental cost (this                                       contribution could be for a sale of one, or more than one units of output).                     Usually we would think of the volume as being a “batch” of some number of                 units sold to a customer at a non standard price. eg the customer made us an offer to buy a “batch” at some suggested price. We decide to sell on the basis of whether contribution margin is + or not.

Firms use “contribution margin” all the time to evaluate whether to take “one time offers”. And, they more often use the concept to examine the profitability of various products and departments of a firm. Say, for example, you are trying to examine possibilities for reorganizing a university, and want to strip away “losing” programs. So, you would proceed in one of two ways: (1) calculate the revenue attributable from each program, and costs associated with each program (these are called direct costs). The difference is contribution margin of each program. It tells us how much profit will go down or up if we wiped out the program. This way of looking at the “contribution” of each program to profit IGNORS all sunk costs, which will need to be paid if the program stays or leaves (like the president’s salary, and the building costs, etc.).

(2) the alternate (and wrong) way to do is to this is to take all the fixed or sunk costs (sometimes called overhead costs) and allocate the share of these common costs that could reasonably be allocated to each of the existing programs (based on payroll size in the programs, or based on square footage used, or whatever). This we create a “fully absorbed” cost for each program. And, if we subtract this amount of program cost from program revenue we will get a measure of “profit” produced by each of the programs. Then you can scan these calculated profits, and decide which program to eliminate? Accountants love these kind of profits, where sunk costs are allocate down to each business unit. Accounting firms make consulting revenue by helping firms develop “fair” methods for allocating sunk costs. Actually these are not good metrics for deciding which business unit is pulling its own weight.

Fundamentally, the sunk costs cant really be properly allocated, so you can’t really be sure that these profits are really a good metric for understanding the “contribution” of particular program. The best approach to judging “which program is not pulling their own weight” is to measure direct revenue into that program, minus direct costs expended. Which revenue would be lost if the program were to be dropped? Which costs would be eliminated if the program were to be dropped? Direct revenue minus direct cost. Or, incremental revenue associated with the program minus incremental costs. This is the way to evaluate the decision to drop (or add) a program, or not. The revenues associated with it are weighed against the costs of doing it. Incremental revenues against incremental costs. Contribution margin!

So if General Motors was evaluating the Chevy Volt, trying to decide to keep the product or not, the idea would be to determine the contribution margin. This is determined by knowing the direct costs and the direct revenues. Or, the incremental costs and the incremental revenues. Common costs in General Motors, which are not associated with any particular product, are essentially sunk, and will be paid one way or the other. So, they don’t bear on the decision to drop the Volt or not. These common costs are the president’s salary, the costs of the accounting department, administrative buildings, etc.

Of course, to be sustainable, all costs have to be covered by revenue for the organization. And, products or departments that are not producing enough revenue to “pull their own weight” in terms of contributing their share of common costs are definitely problems. But, this is different that saying that because they aren’t pulling their own weight of commons costs they should be dropped. Indeed, if their contribution margin is positive, the organization would be worse off if they were dropped. Here is an example for the McDonald’s ice cream sundaes in the Boston stores in a week:

Item                                           Direct (sundae)                     All Products

Revenue	1,000	6,200,000
Frozen Product & Meat costs	600	600,000
Container costs	200	200,000
All other Supplies (including choc sauce, strawberry sauce)	100	400,000
Advertising costs	50	400,000
Labor costs cooks		800,000
Labor costs counter		400,000
Store manager costs		200,000
Building maintenance & depreciation		2,200,000
Margin	50	1,000,000

 

If this rough accounting is accurate, it says that the contribution of Sundaes is $50 a week. Or, said another way, the total profit of the stores would fall by $50 a week if we dropped sundaes from the menu. To be sure, the contribution margin is low, and they may not be pulling their own weight in terms of their share of total store costs. But, determining which of these other costs would actually “go away” if we dropped sundaes from the menu would be hard, if not impossible to compute and even harder to implement. Certainly some of the labor costs are consumed by dealing with sundaes. But whether any of that time could be eliminated seems doubtful. Also, the management costs would likely not be changed if sundaes were, or were not, on the menu. If so, then the labor costs are sunk with respect to sundaes. I would expect if we were considering eliminating all milkshakes, or drive-in services, or other items, it might be possible to compute the potential labor expense reductions that would accompany eliminating the product. But, it seems doubtful that labor costs or building costs would be reduced if the product was eliminated, so we wouldn’t consider it part of contribution margin.

This issue of the “relevance” of common costs (overhead costs) in assessing the sustainability of products in multi product organizations is a big issue in many places. Yes, in the long run, the contributions of revenue of all the products must be large enough to cover the all the organization’s expenses—including all common costs. Management must plan and strategize its product line, operating, and capital decisions to this end. But, in the short term (now, and in the foreseeable future) products that don’t produce enough revenue to pass this test may still be worth keeping if they return enough revenue to make a + contribution margin. That is, their revenues are big enough to cover their direct costs. These are the costs that would go away if the product line were to be dropped. In the event that contribution margin is negative, and revenue is less than direct costs, then the organization would experience an increase in profit if the product were to be dropped.

So, let’s say we are tying to figure out how to bonus executives in a multi-product company. How to find the right metric? We could use some kind of profit measure that accounts for all direct and indirect (overhead) costs. Allocating “common costs” to multiple products (divisions, departments, etc.) is a popular activity of accountants. We can do it of course, using a variety of bases for the allocation: labor costs, revenue, space usage, etc. Or, we could use some “average” overhead rate across the enterprise. So, by one means or another, we can arrive at a full cost, from which we can compute profit. The problem with using such a profit measure as a management performance measure is that (1) it doesn’t focus on “controllable” costs (presumably we are trying to gauge performance on the basis of the manager’s ability to control those things that are indeed subject to her control. (2) we may be highlighting the impacts of the way we have chosen to allocate common costs, which by definition are not directly allocable across the multiple products.

So, “contribution margin” or Revenue – direct costs turns out to be a pretty good way to gauge management performance. Sure, overhead or common costs need to be covered. But, there are two problems with using a full cost measure of profit as a performance metric (1) managers will (and do) fight like cats and dogs over the exact algorithm that is use to do the allocation, because of the impact the basis will have on the resulting “profit” measure. Companies waste vast amount of management time squabbling over the method of allocation. (2) These costs are not controllable by the managers of product lines directly— indeed the overhead rate (common costs) ought properly be one of the metrics used to judge the performance of those actually in control of it—top management. Pushing it down to the performance of product line managers is a sign of lack of accountability of upper management. For example, recentralization of many traditional line functions will increase “common costs” or the “overhead rate”. Yes, and makes it harder to judge line managers who no longer have control of certain functions, and makes it appear that the resultant increase in overhead rate is not the direct responsibility, and choice, of top management.