So, we’re in a crazy political period, and it’s hard to know just what is true in a political ad and what isn’t true. In the investment business, however, we have extensive rules on disclosure to investors, and those rules are in place to provide all stakeholders- including investors- enough to information to make informed investment decisions.
I was pretty blown away by a recent article about startup firms touting the fact that they generated a positive contribution margin– and inferring that contribution margin equals profit.
It doesn’t- and it’s critically important that investors understand the difference.
Contribution margin- defined
Contribution margin is defined as (sales – variable costs), and it’s important to realize that the formula excludes fixed costs. Let’s go through an example to explain the concept:
Fancy Garments make a line of jeans that the firm sells for $80 a pair. The company incurs variable costs for denim and other fabric (material costs), as well as labor costs to run sewing machines and to perform some manual labor on each pair of jeans. The variable costs total $50 per pair, so Fancy Garment’s contribution margin is ($80 sales – $50 variable costs), or $30 per pair (per unit).
Breakeven formula, target net income
Does Fancy Garments have other costs to cover? Well, sure….
The company has fixed cost to lease the factory, and to ensure the machinery, equipment and other assets owned by the company- just to name a few. Assume that Fancy Garments allocates fixed costs of $10 per pair to each pair of jeans. The true profit recognized for the jeans is:
($80 sales – $50 variable costs- $10 fixed costs), or $20 per pair (per unit).
The formula we just used to figure out the total profit can be used to compute breakeven:
(Sales – variable costs- fixed costs = $0 profit)
For a given set of variable and fixed costs, you can figure out the sales level needed to reach your breakeven point- to generate $0 profit. Now, that may not sound very exciting, but the first step in planning your business is to cover all of your costs. Hence, the breakeven formula.
What contribution margin says
Think of contribution margin this way: It’s an amount that the company uses to cover fixed costs- and any amount that is left is profit. However, contribution margin is NOT profit, because it excludes fixed costs.
Let me say it another way: the objective of placing a sale price on your product is to recover all of your costs and generate a profit. If you don’t include all of your costs in that pricing decision, you’ll generate less profit than you think.
Sort of profitable- but not really
This recent Bloomberg article explains how startup’s are approaching investors in an increasingly competitive market for investors:
“To project a healthy business to skeptical VCs, job candidates, and potential business partners, companies have started shouting to the world how they are (or soon will be) profitable—at least, by some definitions of the term.”
The article presents some great examples, using some startups we all know:
“Uber said it was profitable in the U.S. and Canada during the first quarter of this year. Lyft said it is “on a clear and defined path to profitability.” Postmates said it will be profitable by the end of 2017. DoorDash is “cash-flow positive” in some markets. TaskRabbit will be “profitable profitable” by the end of this year. It “won’t be too long” until Airbnb is profitable. Instacart is “gross margin profitable.”
In each case, sales was less than (variable costs + fixed costs). The firms were not yet profitable.
So, why is this a big deal?
“Well, so what?”, you might say to yourself. “They’ve got a great concept and a growing customer base- the profit will come soon enough”. OK- but keep this in mind: successful companies are viable over the long term because they can consistently generate earnings from their day-to-day operations. They open the doors in the morning, turn on the lights- and they know how to generate profits. Ultimately, isn’t that what makes a company valuable?
As always, these posts are for informational purposes only. Consult a financial or tax advisor as needed.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(website and blog) http://www.accountingaccidentally.com/
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