In this post, we’re focused on the questions:
How much from each sale is left to pay for your fixed costs?
How many more do you need to sell in a period to bring in the same amount to pay for your fixed costs?
Using these, you can start to work out how much you should (or shouldn’t) discount your products. Are you thinking about running a 75% off special for Black Friday? Read this first.
Data-based marketing
This series of blogs was inspired by the book How Brands Grow: What Marketers Don’t Know by Byron Sharp, which I highly recommend.
After decades of market research for dozens of the world’s leading brands, Byron and the researchers at the Ehrenberg-Bass Institute pulled together the data they’d collected into 11 marketing laws formed by generalising their empirical observations.
These laws spin the received wisdom about how to market on its head – this tome is paradigm-shattering.
I’m all about data, so it appealed to me immediately when I learned that they used lots of data to figure out what works and what doesn’t. I bought and read the book immediately.
I’m quite late to the game (this book was published in 2010), but the laws are general and already proved their mettle for decades before then, so they are still incredibly valuable.
Instead of doing what everyone else is doing, based on theories and gut feelings, how much more effective will your marketing budget be when you base it on the data of what actually happens in the real world?
Can price cuts be profitable?
Whilst the whole book is well worth reading (and with all the tables in it, I recommend reading it versus listening to it), one concept jumped out at me that I really wanted to share here.
In Chapter 10, “What price promotions really do,” authors John Dawes and John Scriven address the question: Can price cuts be profitable?
If you offer 50% off (perhaps for a Black Friday special), and you sell 75% more products, have you made or lost money?
Or if you slash prices by 20% and win 40% extra sales?
What if you cut prices by 10% and win 15% extra sales?
Let’s find out.
How do you find your contribution margin?
Margin usually refers to a percentage, but contribution margin is an exception. It’s simply a number.
The contribution margin is:
Selling price – Variable Costs
It’s how much you have from each sale to cover your fixed costs.
You might be the retailer, buying it in to resell it, so your variable costs are predominately comprised of the purchase price from the manufacturer.
Or, you might be the manufacturer selling it to retailers or direct to consumer. In this case, your variable costs are predominantly made up of the materials and labour needed to build the toaster.
Either way, let’s say your variable costs are £23.99.
Then, your contribution margin is:
£39.99 – £23.99 = £16.00
How do you find your contribution margin ratio?
There is a percentage you can find with this metric – they call it the contribution margin ratio.
To find it, you calculate:
Contribution Margin / Selling price
So, continuing with our toaster example, we would have:
£16.00 / £39.99 = 40%
What is your contribution margin?
Are you thinking of putting a particular product (or service) on a deep discount soon? Then work through this with me!
Go grab your management accounts to find your variable costs for that product.
Then work out your contribution margin.
If you don’t yet have management accounts to show your variable costs for that one product:
If you are reselling it, use the amount you pay to buy it in.
If you are making it, for now, use your overall direct costs and your average selling price for all your goods.
Do work out your direct costs and variable costs per product or product line soon, though, because it will help you make the fine-tuned decisions you must to help your company thrive.
If you are a service provider, your direct costs are usually minimal and difficult to split by service. If this is true for you, then use your overall direct costs and your overall sales.
What does your Contribution Margin tell us?
Essentially, it tells you how much of every sale is leftover to cover your fixed costs.
How can you use your Contribution Margin?
You can use it to judge whether to keep or release certain aspects of the business.
When the contribution margin of some part of your business is negative, you should let it go – because it means you’re losing money on every item you sell.
When the contribution margin is positive, you should keep it. This means you have the potential to make profit in that part of your business. If it’s operating at a loss right now, that means you need to boost sales to see those profits.
You can also use it to tell how much you’ll need to increase your sales when you drop your price in order to break even – or, better yet, make more profit. This is what we’re focusing on in this entry.
How can you use your Contribution Margin and Contribution Margin Ratio to work out what discount amount could be profitable for your product or service?
Using the Contribution Margin Ratio
Firstly, the ratio gives you an upper limit for discounting.
Our contribution margin ratio for our toaster is 40%. This means 40% of the sale price of the toaster is leftover after building the toaster to pay for our fixed costs, like rent, admin, insurance, etc.
Thus, we know that if we discount our toaster by 40% or more, we’re making a loss, because we still must pay all those other expenses.
So, right off the bat, we can see that the passing idea we had to do a Black Friday 75% off sale means we’d make a loss on every toaster.
That’s not to say we couldn’t or shouldn’t run that sale – but we’ll need to carefully consider how we’ll capitalize on the extra sales in order to make it worth our while. That discussion is beyond the scope of this post.
Using the Contribution Margin
Which brings us to focusing on your contribution margin.
If you know you usually sell 1,000 toasters a week, then with a contribution margin of £16 each, you know your total contribution margin from your toasters is £16,000.
If you discount the toasters by 5%, 10%, 20%, 25%, or 30% for one week, how many toasters do you need to sell to still bring in the same £16,000 contribution margin from your toaster sales that week?
The answers are:
| Discount | Sales boost needed | Total toasters sold |
|---|---|---|
| 5% | 14% | 1,143 |
| 10% | 33% | 1,333 |
| 20% | 100% | 2,000 |
| 25% | 167% | 2,666 |
| 30% | 300% | 3,997 |
Once you’ve calculated that, you can then judge whether the marketing you have in mind to boost sales can potentially boost the sales that much (preferably using data from historical campaigns), so you choose an appropriate discount amount.
How do you find the sales boost needed for each discount level to maintain a steady contribution margin?
You’re in luck – I’ve built you a spreadsheet to make this part easy!
Simply click here to get it, then click on File, then Make a Copy. Now you can play around with your own numbers.
Put your own sale price, variable costs, and usual number of items sold per period in the yellow squares. The rest will update automatically. Your results are in light purple.
For example, you can see that if you discount your toasters by 15% (in column F), you’ll need a sales boost of 60%, selling a total of 1,600 toasters that week in order to still bring in your usual £16,000 contribution margin that week.
Every toaster you sell after 1,600 that week should boost your overall company profit by £10.
When the discount becomes greater than the contribution margin, there are no results shown on the spreadsheet because the whole idea breaks at that point. No matter how many toasters you sell, if you’re selling them at a loss, you simply can’t bring in anything to cover your fixed costs.
What is the calculation for the sales boost needed?
It’s embedded in that spreadsheet, but in case you’re looking for the mechanics of how to calculate it, it is:
Expanding the example with a 15% discount, we have:
£16,000 weekly contribution margin
1,000 sold per week
£10 contribution margin per toaster after 10% discount (Discounted price of £33.99 minus Variable costs of £23.99 = £10.00 Contribution Margin)
Then the calculation is:
60% more than 1,000 works out to 1,600 toasters, so that’s how many you’ll need to sell that week as a minimum.
What should you know about your Contribution Margin?
As ever, consistency is key.
Be sure to keep a note of how you’ve categorised your expenses into fixed versus variable, and continue to do that every time going forward.
Then, you’ll be able to compare historical data, too: Has your toaster’s contribution margin increased or decreased this year compared to last year? Why?
Conclusion
In this post, we’ve focused on the questions:
How much from each sale is left to pay for your fixed costs?
How many more do you need to sell in a period to bring in the same contribution margin?
We’ve seen how the contribution margin ratio helps you immediately set an upper limit to any discounts.
We’ve seen how to use the contribution margin to help you work out how much to discount your products. And you’ve even come away with a spreadsheet already set up to help you with that!
The Fixed and Variable Costs series
Hi, I’m Sara-Jayne Slocombe of Amethyst Raccoon. I help your small business thrive using the power of your numbers, empowering you so that you have the confidence and knowledge to run your business profitably and achieve the goals you’re after.
I am a UK-based Business Insights Consultant, which means I look at your data and turn it into information and insights. I separate the noise from the signal and translate it all into actions that you can actually take in your business.
I also facilitate the Power Pod Roundtable, which is a business discussion group.
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