By CHARLES FRANCE & MICHAEL P. COLLINS, Author, Saving American Manufacturing

This is part two of a two-part piece. Part one can be found here.

This is a fundamental and critical concept: firms should want to sell products that have higher contribution margins. Pricing policies and marketing strategies that focus on high contribution margin products and services will generate more profit for the firm.

 TABLE 1 Traditional Format Cost Accounting Format Sales 1,000,000 100% Cost Good Sold Fixed Costs Variable Costs Materials 550,000 550,000 55% Labor 150,000 150,000 15% Mfg. OH (Depr., Salaries) 50,000 50,000 5% Cost of Goods Sold 750,000 75% Gross Profit 250,000 25% S,G, & A Salaries 75,000 75,000 8% Rent 75,000 75,000 8% Commissions 15,000 15,000 2% Taxes, Dues, Sub. 10,000 10,000 1% Office Supplies 3,000 3,000 0% Adv. & Promo. 2,500 2,500 ______ 0% Total S,G,&A 180,500 18% Pre-tax Income 69,500 7% Total Fixed and Variable Costs 215,500 715,000 Contribution Margin \$ 285,000 Contribution Margin % 29%

Knowing CM\$ and CM% is important to small manufacturers firms because it:

1. Shows the inherent profitability of jobs, work orders, products and customers.
2. Shows the winners (more profitable) and losers (less profitable) in the firm’s product and service offering.
3. Can be used to develop pricing policy.
4. Can be used to develop sales and marketing strategies.

F. Breakeven sales is that amount of sales volume that equates to total expenses, both fixed and variable, inclusive of cost of goods sold and S, G & A.

Since total sales equals total expenses, there is no profit; hence, the firm “breaks even.” The formula for determining breakeven sales is fixed costs divided by CM% (contribution margin percent).

 Table 2 Breakeven Sales Total OH (Mfg. OH + S,G&A) \$215,500 29% = 743,103 Contribution margin

In Table 2, the firm’s fixed costs are \$215,500 and its contribution margin percent is 29 percent, resulting in breakeven sales of \$743,103. This means that, at a sales volume of \$743,103, the firm’s expenses are completely covered and there is no profit.

Knowing breakeven sales is important to all manufacturers because it:

1. Shows the lowest volume of sales needed to turn a profit.
2. Can help the firm establish sales goals\objectives for inside\outside sales representatives and distributors.
3. Can help management determine if there is too much overhead.
4. Can direct management to seek efficiency\productivity improvements to lower direct materials and labor costs.
5. Can serve as a basis for establishing minimum pricing policies.

Note: Reducing OH (e.g. fixed costs) and maintaining CM at 29 percent lowers breakeven. Increasing CM% (e.g. lowering variable costs and\or increasing selling price) also lowers breakeven. Thus, fixed and variable costs, and the contribution margin working in tandem can be used to decide on cost reductions, efficiency improvements and pricing strategy.

At this point, our firm has established all of the ingredients for a pricing policy. Price setting then becomes a function of determining the direct material and direct labor content, and calculating the selling price (SP) that will produce the target CM. If the market will bear a SP resulting in a CM higher than the target CM, the firm is OK. Conversely, if the market won’t accept a SP with the target CM, the firm will then know how far down it can negotiate SP, as long as it doesn’t go below the CM minimum — or negotiate increased volumes to offset the loss in contribution margin. Likewise for proposed discounts, the firm will be able to calculate the amount of discount it can accept and still remain within the pricing policy.

A common belief held by manufacturers is that price discounts can be justified because, even at lower prices, the additional volume covers overhead. A review of the CM explanation earlier will show that this is true only if:

1. The firm is operating above its breakeven sales levels.
2. The proposed discounted project, in fact, possesses a positive contribution margin.

If these two conditions are not met, the firm’s acceptance of a price discount will result in a net loss because overhead is not being covered — the contribution margin is insufficient to contribute to overhead and profit.

To read part one of this two-part series, please click here. Michael P. Collins is the author of the book Saving American Manufacturing. You can find more related articles on his website via www.mpcmgt.com.