The power of marginal revenue
Understanding the concept of marginal contribution can be a powerful weapon in setting strategy. Once overheads have been covered every extra dollar of sales can often have a dramatic impact on the bottom line. If I was to ask most business people what their marginal contribution is they will either not know or will guess a number that is about their current gross profit margin. In my experience the current gross profit margin underestimates considerably the real contribution that an extra dollar of sales will make in most cases. I also waste a huge amount of time arguing with accounting professionals about fully costed operations and the allocation of overheads from head office to operational units.
In this article I have taken some real data from a business that I know well to illustrate the value of focusing on marginal contribution. The table below shows the basic profit and loss of one manufacturing plant in a fairly large industrial conglomerate. The business has many manufacturing facilities located in different places and has a large head office infrastructure whose costs must be met before the enterprise turns a profit.
Not shown in the table is the $1,500 of allocated head office costs (overheads that are incurred by the group and which the accounting system allocates on the basis of revenue earned by each operating unit). In year 1 the head office beanies were looking at a loss of $1,750 from this factory and they were pushing the CEO to close the plant because it lost nearly 16% of revenue and the thought was that this factory would never make a profit.
In year 2 this plant had a great year. Revenue increased by over 60% but what is really interesting is that the indirect expenses increased only slightly from $2,550 to $3,100 (or 20%) and the gross profit rose by more than 200%. Looking more closely at the gross profit line the gross margin as a percentage of revenue rose from 21% to over 38% and even more interesting the extra $7,000 of revenue produced an extra $4,700 of gross profit (or a marginal gross profit contribution of a whopping 67%!!)
How is this possible?
It is very simple really and the explanation is as follows. In this particular business raw materials account for somewhere about 25% of sales (for every dollar sold around 25c must be spent on raw materials). The rest of the direct costs are factory labour and in this particular factory output was able to rise significantly with little change to labour. This was done by increasing throughput through the plant by adding very few people to the labour pool. So the people on the shop floor were able to cope quite easily with the increased throughput demanded when it came and as a result the plant enjoyed a huge increase in its profitability, which nearly all dropped straight to the bottom line. The increased volume clearly required some more direct labour and some more office staff, but not a whole lot. In the end the marginal contribution margin for this particular plant was over 60% (costs went up by 40%, of which 25% was accounted for by raw materials purchased).
The point is that once overheads are covered and a business is operating at or near profitability then the value of extra sales is enormous.
Traditionally people will think in terms of their average gross profit margin (in the case of this business 21% in year 1 and 38% in year 2 – and this is what the head office accounting staff were thinking when considering closure of the plant). In this case however much closer to 67% of each extra dollar of revenue dropped straight to the bottom line and the effect on group profitability was dramatic. Remember that this particular enterprise has many operating centres and the costs of head office which are substantial are not impacted at all by the increase in volume at the plant.
In summary I urge managers to look clearly and carefully at marginal contribution figures associated with their business and suggest that allocation of overheads be taken out of this analysis as overhead allocation from cost centres clouds the thinking and makes clear decision making more difficult.
The overheads should be pretty much fixed (and in this case they were indeed fairly well fixed- a small increase in overheads at the factory was required but no increase at head office was required to support the increased volume of business. The marginal value of extra sales is probably much higher than you think!!