Who's putting the company on their back?
Using contribution margin to judge products, geographies, and business units on their own merits
Heyyooooo, before we jump in, Walter and I want to update the Mostly crew on our latest milestone. Thanks for making this newsletter a success, and most importantly, keeping my local Culver's in business.
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