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  • 🔫 Marginal Contribution - Your secret weapon for a better P&L

🔫 Marginal Contribution - Your secret weapon for a better P&L

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  • 💭 How to use marginal thinking to improve your P&L

  • 🥴 FIFO and LIFO for dummies

  • 📖 The best book on investing I’ve ever read

THE DEEP DIVE

Marginal Contribution: How to unlock better decisions for your P&L

When reporting an income statement, you are, by definition, looking at a position in total.

The revenue is reported in total (broken down by 2-4 segments for public companies). Margins are weighted averages. Weighted average gross margin %. Weighted average SG&A %.

But Income Statements are not managed on averages.

At least not day to day.

They are managed in increments; micro decisions.

For example:

  • Do we discount our prices by 5% to win that new customer?

  • Should we hire that extra IT headcount?

  • Do we change supplier to one who is 10% cheaper but demands 7 day payment terms?

Great financial performance is a products of 1,000 great micro decisions. All under one clear direction. That’s where the magic happens.

Having the right metrics and thinking models to drive day to day P&L decision making is critical.

This is not easy.

Balancing marginal decisions made day to day. All whilst making sure they accumulate to the right answer in total.

How do we do this?

Introducing Marginal Contribution

Marginal contribution is a P&L metric. A definition of profit.

You won’t find marginal contribution on public facing income statements. It’s too commercially sensitive for that. Too spicy for the public domain.

But it’s more important than gross margin.

Marginal contribution = Total revenue less total variable costs.

Marginal contribution is the financial contribution towards covering your fixed costs.

Marginal contribution > fixed costs = operating profit

Marginal contribution < fixed costs = operating loss

Gross profit is a metric defined by cost classification.

Marginal contribution is defined by cost behavior.

Cost classification isn’t as important as cost behavior when it comes to decision making.

It’s not even close.

Marginal contribution becomes most potent when expressed as a % of sales, or per unit.

I.e. if marginal contribution per unit is $1 this means for every unit sold you will be $1 richer in the P&L.

Now, this is a tool you can do something with. Drive incremental day to day decision making

Let’s build this up with an example.

Decisions are made at product and department level, not in total. And here is the beauty of marginal contribution. We can establish different contribution metrics for each unit of analysis

For example:

Example Contribution Grid

Now we’ve really brought the P&L to life.

We’ve got something we can take action on. At a headline the business is doing well; a 10% Operating Income margin.

But under the skin there is much more that can be done on the edges of the P&L that can have a huge impact on the total

For example, here are some conclusions we could draw from this:

  1. Scooter B has a negative marginal contribution (-40%). We would have more profit in $ terms if we simply discontinued this line.

  2. We may be able to reduce our Scooter factory fixed costs (salaries, and utilities) if we discontinued scooter B

  3. Our margins on Escooter B are very high. Perhaps we could drive more sales volume by investing some of that margin in reduced prices, and have more contribution $ overall.

These are all decisions at a level that actions can be taken.

This is where we turn a ‘top down’ aspiration into real life.

Let’s see what happens to the P&L in total if we implement the recommendations above.

We have:

  • Eliminated los making scooter B

  • Reduced fixed costs by 33% in the Scooter Factory

  • Reduced prices on E-Scooter B (and contribution margin from 73% to 60%), leading to much higher sales volumes

The result:

We have increased operating income from $30 to $80, margin from 10% to 27%.

We have transformed the shape of our income statement (for the better) by driving better marginal decision making.

This is a simple example to illustrate a point.

In real life; you could have thousands of products, categories, departments, locations. But it shows how you can move a P&L through understanding the marginal components of your business.

Marginality Paradox

Marginal contribution analysis is rocket fuel for financial performance.

BUT it does come with a health warning.

In the wrong hands and with the wrong controls, it can be easy to justify profit destructive decisions.

Let me explain.

Imagine a business with $10m revenue and 30% marginal contribution. $2m of fixed costs. So $1m or 10% Op Income.

There is an opportunity to win $5m of new business, but at prices that are lower. A 10% marginal contribution on new business to be precise.

Marginal thinking would say that this generates an extra $500k of marginal contribution. Yet fixed costs wouldn’t move.

So we are now earning $1.5m of op income on $15m revenue. Yes marginal contribution % dilutes, but so does fixed cost %.

Net net, Operating income margin % maintained, but on a bigger revenue line. So we have more $ operating income in total, and as the old saying goes “you can’t eat a percentage’. Everyone happy, right?

Well, in theory, yes.

But what if you took the same logic to the $10m pre-existing revenue. After all very few business have truly perpetual revenues without price sensitivity.

Let’s say eventually all revenue gets renewed on a 10% MC. In this case your marginal contribution will tend to 10% over time.

This would mean even on $15m turnover you are now failing to cover your fixed costs.

This is easy to control in smaller businesses. Price and cost disciplines are well centralized around a couple of people.

But what about a larger business with many people making micro decisions?

If everyone starts justifying their decisions based on the business being ‘marginally better off’, that same argument holds for any decision where marginal contribution margin > 0%.

But if marginal contribution tends to zero, you dilute all of your contribution margin away.

This is the marginal contribution paradox. No-one piece of volume in itself must cover the fixed expenses (and profit expectation). But enough of them must to deliver in total.

The art of great operational P&L management lies in making decisions such as these correctly.

That negative contribution product, might look like a dog at face value. But what if its used as a price fighting loss leader to drive footfall and volume across a whole customer shop.

Walmart are masters of this.

They are not afraid to dilute their margins. This even includes happily listing negative gross margin products. All to drive improved total net operating income. It requires real discipline and masterful mix management.

Towing the line to ensure fixed costs are covered. Yet ruthlessly driving cost savings and passing back to customers in lower prices.

Actions you can take:

  1. Build your Marginal Contribution Income Statement grids (like the example above)

    1. Identify marginal unit of analysis (products, product categories, departments, locations, etc)

    2. Calculate marginal costs per unit

    3. Overlay marginal revenue to calculate marginal contribution ($, % and Per Unit)

    4. Attach fixed costs at the right level

  2. Review this marginal grid for opportunities. Specifically

    1. Set marginal contribution ‘hurdles’ that ensure fixed costs are covered. Set rules around how and when this hurdle can be breached. Elevate sign off

    2. Negative contribution margin - are they driving value elsewhere. If not… kill them.

    3. Anything dilutive of total contribution margin, should be growing. If not, it should not be priority volume.

    4. Understand where fixed costs attaches, and seek opportunities to simplify and remove.

    5. Seek opportunities to grow contribution margin in $ through volume (lower prices)

    6. Seek opportunities to grow contribution margin through higher prices and maintain volumes.

    7. Beware of mix effects

  3. Use the above to set parameters and hurdles for marginal decisions and implement in the business. Bake into OKRs at team member level

  4. Measure success and review relentlessly

Note: This week’s post was a part 2 to an earlier post on cost behavior. We ignored mixed costs in the analysis this week. Next week, we will consider the role mixed costs play in contribution margin as we bring part 1 & part 2 together and get deeper into unit economics.

MEME OF THE WEEK

Well … that’s one way of explaining it.

BOOK CLUB

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Oaktree Capital are a hedge fund behemoth and pioneer of distressed credit investment. I’ve met with and presented to MDs from Oaktree myself; I can vouch for how smart they are.

In this book you get a first hand tour of the fundamentals of economics, markets and investing from one of the best investors of the last 50 years.

Its tone and simple illustrations make it a more engaging read than any other book on investing I’ve read. The ‘first principles’ method of teaching make the lessons timeless.

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Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend. But I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need to make the right decisions.

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