example will make this seemingly crazy mathematical formula make sense. Suppose you sell a product for $100 and make a 10 percent profit; your break-even point is $100—$10, or $90. However, if you add 10 percent to $90, you get $99, $1 short of what you want. However, if you divide $90 by (1.00—.10), you arrive back at $100.
Now go back to Figure 6–8 with a break-even point of $1,996. To charge enough to make a 12 percent profit, you divide $1,996 by 0.88 and come up with a final cost of $2,268.
Contribution Margin and the Impact on Profits
For those of you who are still scratching your heads over the Accounting 101 sidebar in the last chapter, rest easy. You are not alone. The fact of the matter is that math scares lots of people, primarily because the language of math is so different from normal human communication. For fun, take the little quiz in Figure 7–1, the “Math Terms Worksheet” on page 88, to test your math prowess.
FIGURE 7–1: Math Worksheet
“Mathematics is made up of 50 percent formulas, 50 percent proofs, and 50 percent imagination.”
—UNKNOWN
How many were you able to check off? For those of you who know all ten terms, you are in the wrong field. Close the book and contact MIT immediately. But seriously, knowledge of higher math is not a requirement for success in business. Even those with limited exposure to algebra should be able to master the concepts of contribution margin presented in this chapter.
How to Calculate Contribution Margin
Contribution margin is a valuable mathematical tool that will help with your financial planning in two important ways. First, it will tell you how much revenue you must generate during the year in order to break even, and second, how much profit you will make on each dollar of revenue after reaching your break-even point. The major difficulty is initially estimating the amount of annual revenues your company expects to generate. Once again, we suggest communicating with industry associations, fellow contractors, and former employers to arrive at a reasonable revenue projection. Also look for websites and articles online such as Construction Business Owner (at www.constructionbusinessowner.com) to learn more about the financial side of your industry and how to make your business profitable.
Keep in mind that “profit,” as used in this book, is unlike the actual taxable profit that a company reports on its state and federal income tax forms. Other factors, such as depreciation and prepaid expenses, have an effect on taxes due. In addition, the accounting method, cash or accrual, has significant effect on taxes. This is just another reason why it is critical to engage a qualified accountant to plan your year-end tax strategy and to prepare tax returns. Your accountant should also understand the big picture and not only focus on each year separately. Tax planning for one year can and will affect upcoming years, especially when making purchases or reviewing income patterns. Make sure your accountant is also thinking long term.
Contribution margin is defined as “the amount of revenue remaining after paying direct costs and variable costs that is available to pay fixed costs and profits.” It is used as both a dollar amount and as a percentage.
The formula we will use for contribution margin is:
Contribution margin (CM) = Revenues—(Direct costs + Variable costs)
Using the example in Chapter 6 (Figures 6–2 and 6–5 on pages 72 and 77), taking a bit of artistic license and estimating annual revenues at $900,000, you arrive at the following contribution margin:
CM = $900,000—($597,293+ $86,120)
CM = $900,000—$683,413
CM = $216,587
What this shows is that you have $216,587 available to pay for fixed costs, the expenses that do not change even when revenue changes, and profit.
A new formula calculates the contribution margin ratio:
Contribution margin ratio (CMR) = Contribution margin ÷ revenues
CMR = $216,587 ÷ $900,000
CMR = 0.2406 (or 24.06%)
For accuracy, we recommend carrying out the fraction to four decimal points. For you math cowards, we are nearly finished with formulas. If you read this chapter several times and work through the calculations yourself, it will become much clearer to you. You might even try the formulas with different estimated revenue figures to learn the effect on your budget.
The contribution margin ratio has two useful functions. First, you’ll determine, based on fixed costs, at what point your revenue produces a break-even situation. The contribution margin ratio will probably change from year to year, and we recommend tracking the ratio and using a two- or three-year average when you set up your annual budget. Here’s another useful formula: