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On December 9th of 2004, Tracy McGrady scored 13 points in 35 seconds, putting the Houston Rockets on his back and securing a victory over the bewildered Sacramento Kings.
This was one of the ultimate “Put the team on my back” moments in sports history, alongside Marshawn Lynch’s Beast Mode run against the Saints in 2010, and Reggie Miller’s 9 points in 8 seconds against the Knicks in 1995.
The reality is, every company has a #1 product, a #1 sales geo, and a #1 sales segment putting in the extra work to effectively subsidize the rest. We just don’t like to admit it, because it will hurt people’s feelings.
That’s why in the world of business, contribution margin is a key financial metric because it allows leaders to have honest conversations about a specific part of the business’ profitability.
In today’s issue we’ll cover:
The Art vs Science of contribution margin
Common mistakes to watch out for when calculating, implementing, and communicating results (hint: talking about it the right way is the hard part)
A real life example, plus a free template you can use to calculate contribution margin for your own company
The Art
Contribution margin isolates variable performance by stripping away all the other “stuff” the organization provides. This allows managers to reward those parts of the biz that are outperforming, and call out those that are underperforming.
The outcome helps decision-makers allocate resources more effectively.
The Art of contribution margin is knowing how to take a scalpel to a fully burdened P&L and cut away the right pieces, while allocating others. This can sometimes require some assumptions, which we’ll get to later.
The Science
Unlike Net Income, which looks at the profitability of the whole business, Contribution margin only looks at a subset of revenue and expenses.
When you calculate Contribution Margin, you ignore fixed costs, overhead, and shared resources the business is paying for, and zoom in on the profitability of one segment’s dedicated resources.
Contribution Margin = Sales Revenue – Variable Costs
Fixed costs are your constant business expenses. These remain the same, regardless of more sales volume.
Examples of fixed costs include:
Rent
Finance and HR salaries
The CEO’s salary
Interest expenses on debt
Company wide tools (like Slack)
Product and Engineering (if they work across multiple products)
Cybersecurity
Insurance
Fixed utilities and office expenses
Variable costs do change as you adjust your production quantities. Variable costs go up or down the more you produce / sell.
Examples of variable costs include:
Direct materials (if you, like, make something you can touch)
Sales and Marketing salaries
Sales Commissions
Hosting / Compute (which may need to be allocated based on usage)
Shipping / Freight
And the resulting contribution margin represents the amount of revenue available to cover fixed costs and contribute towards operating profit.
Contribution Margin Ratio = (Sales Revenue – Variable Costs ) / (Sales Revenue)
What to watch out for
Communication
One of the biggest mistakes I’ve made has nothing to do with the calculation, but rather the way in which I communicated the results.
I remember a specific moment in my career
where I did a kickass analysis of our global sales teams by geography across the US, Europe, and Asia. Based on the output, it was immediately clear that Europe was subsidizing the major investments we were making in our fledgling US Enterprise salesforce…Like, really carrying the water for the US.
I was so excited to share what I came up with that I was blind to how I delivered the results. My dumbass presented it on a global group meeting, and basically called the US GM’s business a bag of shit in front of all his peers.
Yes, my numbers were right.
But no, you shouldn’t say part of the business is dead weight without pre-socializing the findings. There was a web of prior decisions that put us where we were, and an even messier nest of political dynamics I was ignoring. And I set up that leader to react to ugly data on the spot, in front of his colleagues.
Woops.
Allocation
From a technical standpoint, one of the foot-faults you may make when calculating contribution margin relates to marketing spend. This is because it’s never cleanly broken out by product / sales engine / geo. You might have 10% of it allocated directly to a field marketing spend in, say, Europe. But the rest is a nebulous bucket designed to drive traction and enhance corporate branding globally.
What I recommend doing in this scenario is allocating all the unattributable marketing costs proportionally by sales achievement. So if 60% of your sales come from Europe and 40% from the US, split the marketing costs that way as well.
It’s not perfect, since it kinda penalizes the outperformers, but it’s a better approach than leaving a massive chunk of marketing spend out all together and fooling yourself about your true margins.
Circular references
The same goes for customer support costs - you can also allocate this by revenue, or work with the CS team to figure out approximately what percent of their calls come in for one product versus another. In the process you may unearth that a product is not only failing to generate much revenue, but is also driving a disproportional number of break / fix requests.
This would serve as corroborating support to change things up, and perhaps fund the product less. Afterall, the reason why the product isn’t making much revenue may be that it’s always breaking. You’ve found a circular reference.
Getting jiggy with it (na na na na nana na)
I built this example of a fictional software company that organizes its go to market by geography across Europe, the Americas, and Asia, while renewing and expanding their customers from a shared global business unit.
Some takeaways:
Topline:
In this quarter the company did $235M in total bookings, of which $135M was net new biz across the geos, and $100M came from renewal and expansion dollars executed at the global level
Direct Contribution
After segmenting out the directly attributable sales and marketing costs across each geo, you can see Europe was able to do a lot more with its resources compared to the Americas, contributing 55% in direct contribution margin vs 8%
This tells us that its maybe:
More expensive to hire people in the Americas (we could compare average salary by region as a next step)
The European market has more greenfield opportunities (they have it easier)
The American team is just generally not as good at their jobs (don’t say that out loud, though… use the word “enablement”)
We can also see that Asia is currently losing money
This could be a calculated bet; perhaps the company only entered the market a year ago and is intentionally subsidizing the shortfall with European profits
The Renewals business is literally a money printer, with very little Direct expenses, and a fat 96% direct contribution margin (sign me up!)
Total Contribution
We can then start to allocate corporate costs across the geo. Think of this as peanut butter spreading all the remaining OPEX
We’ve done this on a pro rata basis based on a percent of bookings
This admittedly over penalizes Europe and Renewals for their success, overburdening them with expenses, which I’ve done intentionally so you can see how there’s some nuance and art to how you decide to allocate overhead expenses
In theory, the Renewals and Expansion team should be hit with 0% of marketing dollars, since customers are already aware of who you are
On a total contribution basis we see that Europe still comes out on top, while the Americas is only single digits above break even, and, well, Asia is in a hole
Efficiency
While Europe and the Americas are only ~1/3 off in terms of bookings per head, they are more than ~10x off in terms of contribution per head after you factor in expenses
This is exactly why a contribution analysis is important - on the surface they may seem “close enough” in terms of topline; but when you layer in the cost to produce those results, you get a totally different story
If I had a marginal dollar, I’d probably invest it in either Europe or the Renewals business (assuming the renewable book of business is big enough)
I like bookings per head and contribution per head because they each cut through all the noise
Bookings per head is a pure play metric for dollar generation
Direct Contribution per head overlays the actual cost of those people generating the dollars, taking into consideration the cost of labor in different regions
Total Contribution per head fleshes out the rest of the story, giving you the full efficiency of the unit as if it were a standalone business with it’s own corporate costs
Below is a template of the example above that you can use yourself. Feel free to make a copy so you can plug and play.
This is your opportunity, as the financial analyst, to put the team on your back.
Greg Jennings put the team on his back that one time in Madden
Smart stuff I read at 2AM (sources)
A beginner’s guide to contribution margin - Motley
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Quote I’ve been pondering
“If I win, everything will be great, but if I don’t win my friends will still by my friends, my enemies will still be my enemies, and the world will still be the same”
-What they Don’t Teach You at Harvard Business School
