Tim Richardson

Please see the introduction

In the second of five articles, Tim Richardson  discusses a project to implement a stronger, more relevant finance function. It's good to go for some low-hanging fruit, and my proposal for that is a contribution margin P&L.

2. Introduce a contribution-margin profit and loss

IThe image is what I use with my finance team to split our improvement efforts into four areas. The first quadrant is business control. This is the essential and foundation activity of a finance team, and is almost always the most solid and strongest of the four pillars of a modern finance team. There is always room for improvement, but because this is a mature area where finance teams are usually pretty storng, each finance team needs to be considered separately to find areas for improvement. It's hard to write a generic article that would be useful. You're in finance, you get business control.

So for the first improvement article, I'm going off on a slight tangent. I want to show how one of the most basic management reports that Finance makes, the Profit and Loss (or Income Statement), can be easily modified to transform its effectiveness and relevance.

If you want to make a simple change to move the profit and loss report from being an historical document to something that's a tool for decision making, change it to a contribution margin report. Gathering variable costs together and showing the contribution margin is surprisingly easy, yet it transforms the relevance of the P&L.

There are complicated ways to help people understand the relationship between sales, fixed costs and profit. Projects like setting up Activity Based Costing give great insight, but they are time-consuming and hard to explain.

Introducing a contribution margin P&L brings great results with only a few hours of work.

A contribution margin means the following questions can be accurately answered, directly from the profit and loss statement.

• If sales increase by $1,000,000, how much does the bottom line increase?

• Sales can be increased by $500,000 through increased marketing, but how much more marketing is justified?

• Saving fixed costs improves the result. How many dollars of sales would be needed to get the same benefit as cutting costs by $100,000?

• If sales are going to drop by $500,000 in a month, how much fixed cost must be taken out of the business to compensate?

Anyone with an accounting education will know what a contribution margin is: it's the margin left over from sales which is available to contribute to covering fixed costs. 

Consider the following P&L, reporting with a traditional profit and loss (or income statement):

Gross Margin P&L

Now, we are going to change the report, gathering expenses which vary directly with sales. We'll treat Freight as such an expense. You'd also scan through the existing accounts; in this example, G&A contains a commission paid to payment providers for each dollar of sales. This is a directly variable cost.

Depending on how flexible your finance system's reporting module is is, you can have a re-written P&L ready in a couple of hours.

Now, to answer the questions above:

• If sales increase by $1,000,000, how much does the bottom line increase?

The contribution margin means that with $1m extra sales, the benefit to the operating income is $120,000 (12% of $1m). Using the gross margin alone would have lead to the expectation of a $200,000 increase.

• Sales can be increased by $500,000 through increased marketing, but how much more marketing is justified?
  
  

$500k sales brings 60K sales. Therefore, an increase in marketing spending below 60K will result in an increased profit.

• If a dollar of fixed costs can be saved, what's the equivalent in sales?
  
  

The relationship between fixed costs and sales: If the contribution margin is 12%, then a dollar of saved fixed costs = 1/.12, equivalent to $8.33 of sales. For many people in the business, this can be a surpising insight.

• If sales are going to drop by $500,000 in a month, how much fixed cost must be taken out of the business to compensate?

$500k of lost sales a month is $60k contribution margin a month, so $60K of costs need to be removed per month to compensate.

Just getting people in the business discussing fixed and variable costs is a huge breakthrough by itself, and introducing a contribution margin report is a great idea.

Implementation tips

1. Make sure that you separate fixed and variable costs into separate accounts.
2. If your finance system has the concept of account groups or reporting hierarchy, writing a contribution margin P&L is easy. For example, with Accpac you may want to define one new account group called Variable Costs, and then assign variable cost accounts to the new group. Packaging and Postage expense accounts, for example. You simply put the new account group under the gross margin, and define a new subtotal "Contribution Margin".
3. Using MYOB? My MYOB experience is limited to MYOB Premiere.  The poor report writing flexibility is one of the many problems of this software. Basically, a MYOB P&L is tied to the physical order of accounts in the chart of accounts. You would need to move the variable expenses accounts to the top of the expense accounts; this will mean creating new accounts to achieve the renumbering, and merging old accounts with new. If you're going to stick with MYOB, pay the approx $300 for ODBC access and learn how to query MYOB directly in Excel (the ODBC documentation is quite good). This will let you structure reports as you wish; it's a steep learning curve if you don't know SQL, but well worth it. The skills you learn will pay off when you migrate away from MYOB, because SQL queries are the best way of extracting data for transfer to a new system.  The MYOB forums on the site http://www.whirlpool.com.au are helpful. I became an advanced user of this tool due to our migration to Accpac, and due to an ATO GST audit, where queries into the historical MYOB data were very helpful.