Contribution margin – a better way to measure profits

MacBraynes Bus - 1961 Restored Bedford Coach 603CYS - used by Northern Constabulary Pipe BandI’ve already written about fixed and variable costs.  Now let me warn you:  profit or net income is a great way to measure your performance.  However, it can also cause you to make bone-headed decisions.

For example, suppose that you run a bus service between Newark and Pittsburgh.  Adding up the driver salary, gasoline, taxes, maintenance, and a little passenger snack, you figure that the typical bus trip from city-to-city costs $3,000.  Each bus seats 35 passengers, so a passenger-ride costs you  $85.71 (= $3,000 / 35 passengers).  This leads you to set a price of $120.  Then, if you seat 35 passengers at $120, you will receive $4,200 in revenue.  Total profit will equal $1,200 ($4,200 – $3,000).

That’s all fine and well if you live in la-la-land, where you can set whatever price you want and sell exactly the number of seats that happen to be on your bus.  But suppose you live in reality (or in Newark), where sometimes you can’t find 35 passengers willing to fork over $120 for a bus ride to Pittsburgh.

Now suppose there’s one empty seat on the bus.  A passenger comes to you, offering to pay $50 for the ride.  Should you take it?

Conventional wisdom says no.  That seat cost $85.71.  You shouldn’t give it away for $50 and lose money.

Big mistake.  That seat might cost $85.71.  But it’s going to cost you money whether there is a person sitting in it or not.  Almost all of that $85.71 is fixed, and you have no choice.  You can’t do anything but pay it.  If a passenger offers to pay you $50 for the seat, take their money and let them on the bus.  You’re paying for the seat anyway, you might as well take the $50.

This is why airlines sell tickets for peanuts over at Priceline.

How can you apply this to your business?

First, separate your costs into fixed and variable components.  Figure out your total fixed costs and your variable cost per unit.

For our bus trip, assume that all costs are fixed except for the snack, which costs $3 per passenger (the variable cost).

When making a decision to sell a certain product get the highest price you can, as long as it exceeds your variable cost per unit.  Therefore, you can literally auction off the seat (using Priceline) and sell it for anything above $3.  Anything less than $3, and you would lose money on the snack (a big no-no).

Contribution margin is a good measure to use for this decision.  It is calculated like so:

Contribution Margin = Sales price – variable cost.

The basic rule here is unbelievably simple:

Earn as much contribution margin as you can.

Two warnings:

  • This technique will increase your profits (or cut your losses) in the short-term, if you have a few extra seats on a bus, or some empty hotel rooms.   Even if you need to get rid of some products that are about to lose value.  However, in the long term, in order for your business to survive and thrive, sales must exceed your total costs (fixed and variable).
  • Be coy when charging different customers different prices.  Airline customers generally don’t like to pay full price for a plane ticket and then sit next to someone with a screaming baby who got a great deal on Priceline.

[Image: MacBraynes Bus – 1961 Restored Bedford Coach 603CYS – used by Northern Constabulary Pipe Band by conner395, on Flickr]

About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.


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