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ОглавлениеContribution Margin and the Impact on Profits
For those of you who are still scratching your heads over the Accounting 101 sidebar in the last chapter, rest easy. You are not alone. The fact of the matter is that math scares lots of people, primarily because the language of math is so different from normal human communication. For fun, take the little quiz in Figure 7–1, the “Math Terms Worksheet” on page 88, to test your math prowess.
FIGURE 7–1: Math Worksheet
“Mathematics is made up of 50 percent formulas, 50 percent proofs, and 50 percent imagination.”
—UNKNOWN
How many were you able to check off? For those of you who know all ten terms, you are in the wrong field. Close the book and contact MIT immediately. But seriously, knowledge of higher math is not a requirement for success in business. Even those with limited exposure to algebra should be able to master the concepts of contribution margin presented in this chapter.
How to Calculate Contribution Margin
Contribution margin is a valuable mathematical tool that will help with your financial planning in two important ways. First, it will tell you how much revenue you must generate during the year in order to break even, and second, how much profit you will make on each dollar of revenue after reaching your break-even point. The major difficulty is initially estimating the amount of annual revenues your company expects to generate. Once again, we suggest communicating with industry associations, fellow contractors, and former employers to arrive at a reasonable revenue projection. Also look for websites and articles online such as Construction Business Owner (at www.constructionbusinessowner.com) to learn more about the financial side of your industry and how to make your business profitable.
Keep in mind that “profit,” as used in this book, is unlike the actual taxable profit that a company reports on its state and federal income tax forms. Other factors, such as depreciation and prepaid expenses, have an effect on taxes due. In addition, the accounting method, cash or accrual, has significant effect on taxes. This is just another reason why it is critical to engage a qualified accountant to plan your year-end tax strategy and to prepare tax returns. Your accountant should also understand the big picture and not only focus on each year separately. Tax planning for one year can and will affect upcoming years, especially when making purchases or reviewing income patterns. Make sure your accountant is also thinking long term.
Contribution margin is defined as “the amount of revenue remaining after paying direct costs and variable costs that is available to pay fixed costs and profits.” It is used as both a dollar amount and as a percentage.
The formula we will use for contribution margin is:
Contribution margin (CM) = Revenues—(Direct costs + Variable costs)
Using the example in Chapter 6 (Figures 6–2 and 6–5 on pages 72 and 77), taking a bit of artistic license and estimating annual revenues at $900,000, you arrive at the following contribution margin:
CM = $900,000—($597,293+ $86,120)
CM = $900,000—$683,413
CM = $216,587
What this shows is that you have $216,587 available to pay for fixed costs, the expenses that do not change even when revenue changes, and profit.
A new formula calculates the contribution margin ratio:
Contribution margin ratio (CMR) = Contribution margin ÷ revenues
CMR = $216,587 ÷ $900,000
CMR = 0.2406 (or 24.06%)
For accuracy, we recommend carrying out the fraction to four decimal points. For you math cowards, we are nearly finished with formulas. If you read this chapter several times and work through the calculations yourself, it will become much clearer to you. You might even try the formulas with different estimated revenue figures to learn the effect on your budget.
The contribution margin ratio has two useful functions. First, you’ll determine, based on fixed costs, at what point your revenue produces a break-even situation. The contribution margin ratio will probably change from year to year, and we recommend tracking the ratio and using a two- or three-year average when you set up your annual budget. Here’s another useful formula:
Break-even point (BEP) = Fixed costs ÷ CMR
BEP = $187,588 ÷ 0.2406
BEP = $779,235
This means that if actual fixed costs meet the budget, the company will begin to generate a profit when revenues exceed $779,235. How much of a profit will be made is revealed by using the following (and final) formula:
Profit = (Revenue—Break-even revenue) × CMR
Profit = ($900,000—$779,235) × 0.2406
Profit = $120,765 × 0.2406
Profit = $29,056
Even though actual revenue exceeds break-even revenue by more than $119,000, the actual profit is far less because the difference was used for direct and variable costs spent generating the additional income.
For most contracting businesses, the ideal time to reach the break-even point is in early fall; doing so leaves several months to generate a profit. If the break-even point is reached in December, for example, the profit will likely be small. Study Figure 7–2 on page 91, and it should become clear.
Figure 7–2 shows how revenues and expenses grow during the year. Total costs, which include direct, fixed, and variable costs, are shown by the line with arrows. Revenues are shown by the line with tiny x marks. In the example, revenues begin to exceed costs during the month of August and remain ahead of costs for the remainder of the year, resulting in a profit for the company. Of course this is assuming a fairly steady work flow with similarly sized jobs throughout the year. You could have a major job, your largest of the year, in May and June, bringing you past your break-even point much earlier than expected. This can give you an opportunity to allow early profits to grow by year’s end.
FIGURE 7–2: Break-Even Analysis
Establishing a budget, understanding and using contribution margin, and correctly allocating expenses among direct, fixed, and variable costs are only the first steps in implementing a successful budget and estimating system. In order to be successful, expenses and revenues must be monitored on a regular basis and adjusted if necessary. The budget should be reviewed at least monthly for most small contracting businesses and at least quarterly for larger companies. A budget is not a static document but is subject to change and modification during the year. A change in the budget may necessitate a change in the way products and services are estimated, resulting in a price change. The sooner that a company can determine that expenses are not meeting budget expectations, the sooner pricing can be adjusted to reflect the discrepancies.
Figure 7–3 on page 92 is an example of monitoring spending on a monthly basis. Spending through September is compared with the 12-month budget. Column 2 lists the amounts, by category, that are budgeted for the entire year; column 3 lists the amounts actually spent as of September 30; column 4 indicates the percentage of the annual budget that has been spent. Because September represents 75 percent of the year, the expectation is that most expense categories be close to this figure. Amounts that are far over or far under the budget should be analyzed further.
FIGURE 7–3: Budget Analysis
Get a checkup using a spreadsheet set up like this to compare your budget to actual expenses.
While several items are over budget, the totals for each category are acceptable; total direct costs are 76 percent of budget, fixed costs are right on budget at 75 percent, and variable costs are under budget at 68 percent. Two items are worth considering in more detail. Utilities have an annual budget of $1,800, but $1,550, or 86 percent of budget has been spent. An analysis may show that seasonal temperatures caused utility expenses to rise earlier in the year, but they are expected to drop in later months. The uniforms expenses are at 100 percent of budget. Here, an analysis may indicate that new uniforms were purchased in January. No more uniforms will be purchased before the end of the year, so the annual expense will meet the budget. In the example of Figure 7–3, it appears that total spending is very close to the budget, and there is no need to adjust the pricing formula.
A second method of tracking the success or failure of company operations has little to do with the budget or with contribution margin. However, it is a useful tool, especially when used over the course of several years. This method compares actual revenues with real field labor costs, which are regular wages plus overtime costs. It is unnecessary to add labor burden to the calculations. Wages of office staff, sales staff, and executives are not included as they are not direct job costs. Consider Figure 7–4.
As shown, at the end of September 2013, revenues were $580,000 and total wages were $127,500. Therefore, each dollar spent on field wages generated $4.55 of revenue. In 2014, the amount generated dropped to $4.45, but it rebounded in 2012 to $4.59. For some reason, efficiency dropped in 2014; there could be any number of reasons for this drop, and they aren’t necessarily all bad. It may be that the workforce did work less efficiently and took longer than expected to complete projects. It may also be just a quirk in the calendar—perhaps there was an extra pay period in 2014 or, possibly, several projects were near completion at the end of the month and their revenues are not factored into the equation. But whenever there is a drop in efficiency as indicated by a reduction in sales-per-labor dollar, it is necessary to learn why the drop occurred. Any drop in efficiency is a red flag that may indicate a breakdown somewhere in the company. Perhaps the estimating department did not realize that there was a price increase in materials, or new employees are taking too long to learn their tasks, or the billing department is tardy in sending invoices for work completed. Whatever the reason, it must be corrected immediately.
FIGURE 7–4: Sample Spreadsheet to Analyze Sales per Labor Dollar
Tracking expenditures and revenues on a monthly basis and comparing them to the annual budget and to previous years’ spending is a fairly simple task that should be done on a monthly basis, shortly after the end of each month. Routine financial check-ups will usually prevent serious problems that can have a negative impact on a company’s bottom line.
Contribution margin is the amount of revenue necessary to break even after paying direct, variable, and fixed costs.
Contribution margin is used to calculate at what point during the year revenues produce a break-even situation.
Contribution margin is used to determine how much profit is made from each dollar of revenue after the break-even point is reached.
Small businesses should schedule a monthly “physical exam” to ensure that spending is in line with expectations.
